The Different Types of Interest Explained: An Informative Guide

Did you know that as of 2018, the average American owed $38,000 in personal debt?

Inevitably, individuals and organizations will need external funding at some point. To leverage this credit, both individuals and organizations will need to pay interest. There are several ways to calculate interest, and you need to be aware of each to understand the potential value you can derive from each scenario.

Here’s a brief guide on different types of interest more commonly available to help you assess your credit options.

What Is Interest in Banking?

Interest is the extra amount of money a borrower pays to a lender on top of the principal sum borrowed.

Although anyone can lend money and charge interest, banks do it for a living. As such, they charge interest on a loan you take to generate a profit while paying you interest on the money you deposit with them.

For any lender, putting their money in high interest investments is the ultimate goal. That includes paying you a lower interest rate than that which they charge borrowers, to make a profit from that spread.

The amount of money you pay (or earn) on interest depends on several factors. These include the total loan amount, the rate of interest, and how long it can take you to repay.

Another critical factor that impacts the rate of interest is how risky the lender perceives you to be.

If a financier feels that your odds of repaying the loan are lower, they will charge you higher interest for the risk they are taking in advancing you the funds.

On the flip side, if the lender is convinced you can repay the loan without difficulty, then you will likely receive a lower interest rate.

Types of Interest Available

When you are looking for a loan, you need to understand each type of interest and how it can best serve you. Let’s look at some of these common interest types available:

1. Fixed Interest

As the name suggests, fixed interest is where a set interest amount is tied to a loan you must repay together with the principal.

A fixed interest rate remains the same throughout the loan’s life. For this reason, it’s the simplest and most common form of interest among consumers.

Since you pay the same amount every month, you and the borrower both know what falls due when making it easy for you to budget.

For example, let’s say you take out a $15,000 loan at 5% fixed interest. Your lender will then expect you to repay $15,750 in total.

The primary draw of fixed interest is that it doesn’t change, which gives you security against turbulent times. But this feature can be a double-edged sword as it means your rate will remain unchanged even when the market improves.

2. Variable Interest

Variable interest is one that fluctuates depending on market forces. Typically, this kind of interest rate is often tied to the movement of a base interest rate, which changes periodically.

As such, if the underlying interest rate on which variable interest is based falls, then the interest rate you pay also reduces. Conversely, if the benchmark interest rate rises, so does the rate of interest which you pay.

In case the underlying interest rate in question dips beyond reasonable levels, banks can raise the variable interest rate you pay to cushion themselves.

The underlying interest rate on which variable interest lies will vary depending on the type of loan or security in question.

3. Simple Interest

Simple interest is a rate that banks regularly use to determine the amount of interest they plan to charge a borrower.

To arrive at simple interest, banks will take the principle, multiply it by the interest rate, and the number of days to arrive at the outcome.

For example, assume you hold a money market account worth $5,000 paying 1.5% interest for three years. The interest you’d earn in this scenario would be $450 < x .03 x 3 = $450.>

Whenever you make a payment on a simple interest loan, it’ll first go to that month’s interest and any remainder towards the principal.

4. Compound Interest

Compound interest is one that’s calculated on the initial principal and money previously earned as interest.

The loan interest for compound interest cases is calculated on an annual basis.

A lender will include that interest amount as part of a loan balance and use that to calculate next year’s interest payments. Essentially it is an ‘interest on interest’ on the loan or credit balance.

How fast compound interest will accrue depends on the frequency of compounding.

When calculating compound interest, you take simple interest and build on it.

Let’s take an example of a $200 bank deposit that attracts 5% interest.

Under simple interest, the bank would pay you $10 after one year. The following year, if the terms remain unchanged, you’d receive the same amount from the bank.

With compound interest, things become more interesting after year 1.

In year 2, the bank will calculate what you earn based on the initial principal ($200) plus the payout on interests ($10). Thus, the interest for year two will be calculated based on $210, which earns you $10.5.

For year 3, your balance of $220.5 will earn you $11.025, of which you add to the current principal amount to calculate the next year’s compound interest rate.

Just as this snowballing effect grows your deposit, so will it increase the loan amount you take. If you don’t pay when it falls due, you’ll owe interest on the amount you borrow plus the accrued interest.

The longer the period in which compound interest is left to work, the more powerfully you will feel its effects.

Understand the Different Types of Interest at Play

Whenever you decide you need to tap credit, you have to reckon with the fact that interest is the price you pay to play. Therefore, you must understand the different types of interest at play and how each can impact you. Once you identify the strengths and weaknesses of each kind of interest, you can discover that which can help you achieve your goals.

Are you interested in learning about entrepreneurship and small business? Check out more of our content for invaluable tips and ideas to drive your entrepreneurial growth.

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