Call On 01922 620008 |

Interest Definition: Types, Examples and Processes

Interest Definition

Interest, in the financial sense of the word, can be defined as the cost of borrowing money. If you take out a loan from the bank, for example, they will charge you interest on that loan. The amount of interest charged depends on many different factors like credit score, type of loan, etc.

There are two main types of interest: simple and compound. Simple interest is calculated only on the initial principal amount, while compound interest is calculated on the original principal as well as any accrued interest. This can lead to a much higher total amount paid back over time!

The purpose of interest is to compensate the lender for the risk of lending money. By definition, it is also a form of profit for the lender. It’s basically how credit providers make money on their services. If you take out a loan of £100 with a 4% interest rate, you’ll pay back £104. The £100 is what the provider had anyway, and they made £4 from the loan.

The flipside to this is that interest allows you to profit from depositing funds with a financial institution. This allows you to make money on the funds you deposit, making it worthwhile, especially when interest rates are high.

What is interest?

Interest is the monetary charge for borrowing, or depositing money and is usually expressed as a percentage of the amount borrowed, or deposited. Interest represents the reward that a lender receives for lending out money.

The concept of interest is beneficial to borrowers as it creates an incentive for others to loan money to them. By shopping around and comparing different offers, you can find the loan with the lowest interest rate and save money compared to other products in the market.

Of course, as with anything financial, there are also some risks associated with interest. The main danger is that it can snowball out of control if you’re not careful. This is especially true for compound interest, which can easily get out of hand if left unchecked.

It’s important to be mindful of the interest rates on any loans or credit products you take out. Make sure you can afford to pay them back in full and on time, or else your credit history could suffer.

Interest is not without its critics. Some people argue that it’s a form of exploitation, especially when it comes to lending money to those who are already in financial difficulty. Others claim that the interest system unfairly benefits the wealthy while penalising the poor. Of course, without interest, there would most likely be nobody willing to lend money in the first place.

There’s definitely room to explore this topic and see it from all sides, and if you’re interested, then it’s well worth diving into financial-orientated books like “The Barefoot Investor”, by Scott Pape. Although Australian-economy focused, this is certainly a book everyone can learn from.

How is the Annual Percentage Rate synonymous with interest rates?

When it comes to credit products, the Annual Percentage Rate (APR) is one of the most important numbers you need to know. This is because APR includes all of the fees and charges associated with a loan, so it’s a more accurate representation of how much that loan will cost you overall.

It’s also worth noting that not all lenders advertise their APR. Some may only list the interest rate, which can be misleading. So, if you’re shopping around for a loan, make sure to ask for the APR.

The APR affects the interest in two ways. Firstly, it determines how much of the loan’s total cost is made up of interest. So, a high APR will mean more of your payment goes towards interest and less towards paying down the principal amount.

How do banks use interest when you borrow money?

Banks use interest to make money on loans in two ways. Firstly, they charge interest on the money you borrow from them. This is how they make a profit on their services. Secondly, they also earn interest on the money you deposit with them.

The amount of interest you’re charged on a loan depends on several factors, including the type of loan, the amount you borrow, and the interest rate. The interest rate is set by the bank and can be either fixed or variable. It’s important that you consider all products to find the best ways to borrow money while minimising your interest costs.

Banks use the money deposited with them to make loans to others. Banks are not charities; they exist primarily to make a profit. When you deposit your money in the bank, the bank uses that money to make loans to other people, and they charge interest on those loans.

What is the history of interest?

The concept of loans first appeared around 3000 BC in Mesopotamia. At that time, loans were typically made between family members or friends and didn’t involve any interest. It wasn’t until the times of Ancient Egypt, around 2750 BC, that the first instances of interest started to appear in written records.

At that time, interest was calculated in the form of grains of wheat. The borrower would have to pay back not only the principal amount but also an extra amount of wheat, which was used to compensate the lender for their lost opportunity cost.

Of course, a lot has changed over the years. Fast forward to 1970s, and interest rates were at an all-time high in the Western world. In fact, in some countries, they reached as high as 20%!

In the 1990s, things started to change. The global economy was in a recession, and interest rates began to fall. This trend continued into the 21st century, and today, interest rates are at historic lows.

Presently, as of 2022, the average interest rate for a 5 year fixed rate mortgage in the UK is around 1.29%. This means interest rates are at an all time low, but this isn’t necessarily a good thing for anyone.

What are the types of interest?

While you can break down interest into ‘simple’ and ‘compound’ types, there are a lot more types of interest out there you’ll need to know. Let’s break down the most interesting ones.

1. Simple interest definition

A simple interest type is where you only pay interest on the principal amount of the loan. This means that if you take out a loan for £100,000, you’ll only be required to pay interest on the £100,000. The interest charged on the loan does not then attract further interest. Simple interest can be a good option for those who want to keep their monthly payments low, but it’ll take you longer to pay off the loan overall.

Example calculation formula for simple interest

To make things clear, this section is all about exploring an example calculation for simple interest. Very simply put, the formula is as follows;

A = P(1 + rt)

The key for this formula is;

A = The final amount paid

P = The initial amount taken out for the loan

r = The annual interest rate

t = The number of years the loan will be paid back over.

So, imagining you’re taking out a loan for £1,000 at a rate of 3.5% for two years, the calculation would look like;

A = 1000(1 + (0.035 × 2)) = 1070

A = £1,070.00

You can use a simple interest calculator, to work this out easily.

2. Accrued interest definition

Accrued interest is the interest that has been earned but not yet paid. This can happen when you make an investment, such as a bond, and then sell it before the interest is paid out. In this case, the new owner of the bond will receive the interest payments, even though they didn’t originally invest in the bond. This is different from other types of interest because it’s earned over time, rather than upfront.

Example calculation formula for accrued interest

To make this a little clearer, let’s have a look at an example calculation of accrued interest. Some things to be aware of include;

Factor = Time Held After the Last Coupon Payment / Time Between Coupon Payments

Interest Rate per Payment = Annual Interest Rate (Coupon) / Number of Payments per Year

Using these two elements, you can work out accused interest using the following formula;

Accrued Interest = Face Value of the Bonds x Rate (Interest rate per payment) x Factor.

For example,

Factor = 90 days / 180 days = 0.5

Interest Rate = 5.0%, Interest Rate per Payment = 0.05/2 payments per year = 0.025

Accrued Interest = £10,000 × 0.025 × 0.5 = £125

This means in this specific example, you’d be paying £125 on top of the amount owed from the bond sale. To make it easy, there are certain accused interest calculators you can use to work out your own finances.

3. Compound interest definition

Compound interest is a type of interest that builds on top of the initial amount you borrow. This means that not only do you have to pay back the original loan, but also the accumulated interest.

In other words, with compound interest, your debt increases exponentially over time. This type of interest is common on bridging loans where the interest is added to the loan, rather than paid monthly.

Example calculation formula for compound interest

A £100,000 bridging loan with a monthly interest rate of 0.48% per month would see the borrower charged £480 in interest for the month. If that interest is added to the loan and compounded, then the following months interest would be based on the new balance of £100,480, rather than the original balance, meaning interest of £482.30.

While this is complex to calculate manually, a compound interest calculator can make it simple.

4. Security interest definition

Security interest is a legal interest in an item that has been used as security for a loan. Security interest can come in many forms, for example a car could be taken as security for a car loan and a house will be taken for a secured loan. Security interest doesn’t refer to the interest paid on a loan, but represents the lenders legal interest, or rights, over a piece of property should a borrower fail to keep up their repayments.

5. Nominal interest definition

Nominal interest refers to the interest rate charged before inflation is taken into account and is also known and a headline, or advertised interest rate. Nominal interest is a term that is most commonly associated with savings accounts and refers to the impact that inflation will have on the value of any interest received on your savings.

Example calculation formula for nominal interest

A savings account that pays 2.5% nominal interest on a balance of £100,000 would see you earn £2,500 over the course of a year. Should inflation sit at 1.5% over the same period, your savings would actually be devalued in real terms, meaning the spending power is now 1.5% less than it would have been at the start of the year.

It can be calculated on a nominal interest calculator, or as described below:

£100,000+2.5%=£102,500 – your savings balance is now £102,500.

£102,500-1.5%=£100,962.50 – inflation has reduced your spending power by £1,537.50

5. Short interest definition

Short interest is the number of shares that have been sold short by investors but have not yet been repurchased or closed out. This type of interest represents an investor’s financial interest in a particular share, rather than the passing of financial interest from one person to another through a loan or savings account.

6. Capitalised interest definition

Capitalised interest is a term used to describe interest that has been added to the balance of a loan. Unlike most loans, where the interest is paid monthly, capitalised interest is added to the outstanding balance and repaid at a later date. This practice is commonly used on bridging loans and is known as rolled-up interest.

Example calculation formula for capitalised interest

An example of capitalised interest is below, this can be calculated manually, or more easily by using a capitalised interest calculator.

A bridging loan is arranged for £100,000 at an interest rate of 0.45% per month, which is rolled up. At the end of the first month, the interest of £480 is then capitalised, meaning that the borrower’s balance has now increased to £100,480.