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What is interest and how does it work?

Interest is the amount of money that lender (one who gives a loan) charges to a borrower (one who takes a loan). Whenever you take a loan, a certain amount of interest will charge on it.

Lending a loan might not be a benefit for anyone, to make it more secure, reliable, and also earn some profit from it, a lender can charge some interest from it. But how can we calculate interest? and what are the factors involved in the calculation of interest?

Factors which include in calculations

Some of the factors which determine the percentage of interest are:

  1. Amount of loan
  2. Loan Type
  3. Duration of loan.
  4. Expected inflation
  5. Borrower credit history, is it safe to give him/her a loan?
  6.  Risk of default

Calculations of interest

Amount of interest usually measured in two different terms, simple interest and compound interest.

1. Simple interest

Simple interest is calculated using the interest rate and the amount of loan both parties have decided. This simple interest is the fixed amount of interest a borrower has to pay at a certain time. For example, if the loan is $20,000, and the interest rate is 5% annually, a borrower has to pay $1000 at this particular time.

2. Compound interest

In economy compounding means to multiply with some factors, ie you have $5 on day 1 , $10 at day 2, and 20$ at day 3. Compound interest is calculated using interest rate, the amount of loan and it is calculated multiple time. Compound interest is usually increasing the amount of interest on the loan, such as interest calculated over interest. After sometime, It will increase the amount of interest to some extent

Nominal interest and Real interest

Inflation has a crucial role in the economy and interest. The difference between nominal and real interest is inflation. Nominal interest is an interest that includes an inflation risk percentage. But real interest is the actual interest ie interest rate with the amount of loan. For example, if the decided interest rate is 7% and the inflation risk rate is 3%, the total nominal interest will be 10%. In this case, the real interest is 7% ie the inflation rate is not included in real interest.

Read about finance.

Types of interest

The general type of interest is

  1. Fixed interest: The type of interest in which both lender and a borrower agree on the amount of interest. Fixed interest will remain the same no matter what happens with the economy or inflation.
  2. Floating variable: The type of inflation in which interest rate is not fixed, it changes over time depending upon several factors such as Federal bank policies, economy, borrower history, and inflation. A borrower may get some ease in floating interest as the interest rate may be decreased due to some reasons.
  3. Prime rate: Banks charge prime rate interest only to creditworthy customers. Banks usually work with a prime rate, as the prime rate is less than the actual interest rate.
  4. Discount rate: Banks use a discount rate to get a loan from the Federal reserve. Banks usually need money to complete their daily transactions, fund shortages, and correct liquidity gaps.
  5. Annual percentage rate (APR): APR is used to decide the interest rate annually, or also fixed the interest rate for a year. This type of interest is applicable the credit card owners.

Conclusion

With interest, we can earn from it by giving a loan to others. It will also help a borrower to invest in the businesses and pay an amount to the lender. This circulation of money will help both parties, and both can get their means from it.

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