Definition
The term interest rate is used to describe the amount charged to borrow money. It is the percentage of the principal paid by the borrower in each time period; typically stated as an annual rate of interest.
Calculation
Interest Paid = Principal x (Interest Rate / Period) x Number of Periods
Explanation
The rate of interest charged to borrowers can vary with the perceived credit risk, or risk of repayment. Borrowers that present a higher risk of non-payment may be charged a higher rate of interest on a loan.
Interest rate is often confused with annual percentage rate, or APR. The APR can be used to compare the total cost of a loan to alternatives. The APR takes into consideration fees and mortgage points as well as the interest rate on the loan. This relationship is demonstrated in the equation below:
APR = Interest Rate + Fees + Points
There are only three variables needed to determine the monthly payment on a loan: interest rate, term, and principal amount.
Example
Bill borrows $1,000 from a local bank at a rate of 10% per year. Bill only needs to borrow the money for six months. The interest payment on this loan would be:
= $1,000 x (10% / year) x 0.5 years = $1,000 x 0.10 x 0.5, or $50
The effects of compounding can be witnessed using our compound interest calculator.
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