Interest Rate Definition

Interest Rate Definition

See Also:
Effective Rate of Interest Calculation
Interest Expense
What are the 7 Cs of banking
Time Value of Money (TVM)
Interest Rate Risk
LIBOR vs Prime Rate
Federal Funds Rate Definition
Treasury Inflation Protected Securities

Interest Rate Definition

An interest rate signifies a borrowing cost. The interest rate definition is the rate the lender charges the borrower for the use of money. Quote interest rates as annual rates, which represent a percentage of the borrowed principal. Interest rates are used in all types of business and consumer loans, including auto loans, mortgages, credit cards, and any other contract that involves a borrower and a lender. A borrower with good credit – and therefore less risk of default – can borrow money at a lower rate than a borrower with poor credit.

Benchmark Interest Rates

Business and consumer loans, as well as interest rate derivatives (see below), often rely on benchmark interest rates, such as the fed funds rate, the prime rate, Libor, or U.S. Treasury rates. For example, a company may borrow money from a commercial bank at a rate equal to the prime rate plus a specified quoted margin. The quoted margin, or spread between the benchmark rate and the interest rate used in the loan, would depend on the credit standing of the borrower.

Interest Rate Derivatives

Furthermore, interest rates are also frequently used in financial derivatives, such as interest rate futures and interest rate swaps. With financial derivatives, the value of the derivative instrument depends on fluctuations in the underlying interest rate.

Calculate Interest on Loan

Use the following equations to calculate interest on a loan:

Simple Interest = Principal x Interest Rate x Time Periods

Compound Interest = Principal x (((1 + Interest Rate)^Time Periods) – 1)

Interest Payment = Principal x Interest Rate

Principal = Interest Payment / Interest Rate

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