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Interest Rate Definition in Economics: From Real to Nominal IR

Interest Rate Definition

An interest rate is a cost of borrowing money, expressed as a percentage of the amount borrowed. It is used to calculate the interest payments that are made over the life of a loan. An interest rate can be fixed or variable, and it can apply to either consumer debt or business loans.

However, there are a few variations in this and different considerations you’ll need to know. This article will take a closer look at what an interest rate is and how it affects both borrowers and lenders.

An interest rate is the percentage of an amount of money that is paid for its use over a period of time. The amount may be borrowed or lent, and the interest rate usually refers to the annual cost of borrowing. It’s how credit providers make their money.

For example, if you take out a £100 loan with an interest percentage of 4%, you’ll end up paying back £104 over the course of a year. That’s the £100 you originally took out, plus £4, which the credit provider then makes for offering the loan in the first place.

The interest rate is usually expressed in two ways: nominal and real. The nominal interest rate is the percentage that’s quoted, while the real interest rate taking into account things like inflation. This means that it shows how much money you’ll actually be able to spend after considering the effects of price rises.

However, while a simple concept, in reality, interest rates and percentages can be a little more complicated. For example, there are economics concepts like real Interest rates and nominal interest rates.

Real interest rates are the financial rates that are adjusted for inflation. Nominal interest rates are unadjusted or “pure” rates. The difference between the two is the real interest rate.

Nominal interest rates are often used when setting monetary policy because central banks can target a specific nominal rate. That said, in practice, most people are more interested in real interest rates. After all, it’s the real interest rate that determines how much purchasing power you’ll have in the future, affecting financial aspects like your credit ratings.

It’s important to understand the difference between nominal and real interest rates because they can significantly impact your personal finances. For example, let’s say you’re considering taking out a £100,000 mortgage with a percentage interest rate of five (5%).

Over the course of 30 years, you would end up paying back a total of £193,256 in interest at that rate. And that’s assuming your mortgage has a fixed-rate interest. If it was variable, this could change dramatically. Even a 1% change in the first year would take your total repayment over the £200,000 mark.

Of course, this is a very simplified example, and there are other factors to consider. However, it does show how important it is to understand the difference between nominal and real interest rates.

Interest rates have been around for a long time. The first recorded interest rate is from the Sumerian civilisation in 3000 BC, where it was used to finance the construction of irrigation canals.

In the centuries that followed, interest rates were used by many different cultures and civilisations, including the Egyptians, Babylonians, and Chinese. It wasn’t until the 18th century that modern-style interest rates were developed where the interest rate was a percentage of the amount borrowed.

Since then, interest rates have come a long way and now play a central role in our economy. They’re used to finance everything from mortgages and car loans to businesses and governments’ economics and financial processes.

Interest rates as we know them today originated from the minds and conversations of economists like Adam Smith, Carl Menger, and Frédéric Bastiat back in the 19th Century. This was elaborated on around 1898 when Knut Wicksell in his book, Interest and Prices, which deep-dived into the theory of economic crisis, using the differences in natural and nominal interest rates.

This was then popularised in the 1930s by John Maynard Keynes in his book, The General Theory of Employment, Interest and Money. In Keynes’ economic theory, interest rates were a tool to help stabilise the economy and fight unemployment.

And so, this is how we got to where we are today, with interest rates being such an essential part of our economy.

Debt is when somebody borrows money from another person or institution. If you take out a loan of £1,000, you are then £1,000 ‘in debt’ to the provider who gave you the money. Debt can come in the form of a loan, where the borrower agrees to repay the money plus interest, or it can be in the form of a bond, where the borrower agrees to make periodic payments.

The default interest rate is the interest rate that a lender charges if a borrower misses a payment. The default interest rate can be anywhere from one to four percent, and it’s usually higher than the regular interest rate. If you owe someone money and you miss a payment, this is defined as ‘defaulting on a payment’, in which this interest rate would then be applicable.

Each country has its own laws governing interest rates. In the United Kingdom, the main law on interest rates is the Consumer Credit Act 1974. This law outlines the maximum amount of interest that can be charged on a loan.

The law states that a provider cannot ever take more interest than the original loan value. There was also a cap introduced in 2015 that said that providers cannot charge more than 0.8% of interest per day.

What are the main interest rate types?

There are many different interest types to consider, and understanding the difference between them is key to understanding how the economy works.

1. Fixed Interest Rate Definition

A fixed interest rate is where the rate of interest charged on a loan stays the same for the entire term of the loan. This means that if you take out a loan with a fixed interest rate, you’ll always know how much your monthly repayments will be.

If you take out a loan with a fixed interest rate of £500 with a 5% interest rate, you will only ever pay back £525, which is 5% of your loan. How you pay this back will depend on your loan term and monthly payments, but it will only ever be £525. 

You will find fixed interest rates commonly on loans like mortgages, personal loans, wedding loans, student loans, and car loans.

2. Nominal Interest Rate Definition

A nominal interest rate is the rate of interest that is quoted when a loan or investment is made. This is the rate that you would see in advertisements and on contracts like mortgages and car loans.

The nominal interest rate is a pretty simple concept. If you take out £100 at 6%, then you’ll pay back £6 in interest. This is most commonly the kind of interest rate you would see on financial things like bonds and any type of loan, typically short-term ones, like a wedding or car loan, and sometimes even student loans.

3. Prime Interest Rate Definition

The prime interest rate is the interest rate that banks offer to their most creditworthy customers. This is usually the lowest interest rate a bank will offer, and it’s used as a benchmark for other types of loans. This could be preferred customers who have proven to have a reliable credit rating, or businesses and large corporations.

For example, if a standard interest rate is 8%, if you have excellent credit, you might be able to get a loan with a prime interest rate of five percent or lower. If you have good credit, you might be able to get a loan with a prime interest rate of six percent.

The prime interest rate is also used as a benchmark for other types of loans, like adjustable-rate mortgages and home equity lines of credit.

4. Simple Interest Rate Definition

A simple interest rate is the rate of interest that’s charged on the original loan amount. This type of interest rate doesn’t take into account any compounding, which means that you’ll only ever pay back the original loan amount plus the interest.

If you took out a £500 loan with a simple interest rate of five percent, you would pay back £525. This is because you would have paid five percent of the original loan amount (£25) in interest.

Simple interest rates are common on credit cards, where you might be charged fifteen or twenty-five percent interest on your balance.

5. Annual Interest Rate Definition

An Annual Interest Rate is the rate of interest that’s charged on a loan or investment over the course of one year. This type of interest rate takes into account compounding, which means that you’ll pay back more than the original loan amount.

For example, if you have an annual interest rate of eight percent, you would pay back £840 on a £1000 loan. This is because you would have paid eight percent of the original loan amount (£80) in interest.

Annual interest rates are common on mortgages and car loans.

6. Effective Interest Rate Definition

The Effective Interest Rate is the rate of interest that’s actually paid on a loan or investment. This type of interest rate takes into account both compounding and inflation, which means that you’ll pay back more than the original loan amount.

Let’s say you have an effective interest rate of eight percent. This means that your nominal annual interest rate is seven point nine five percent, and your inflation rate is point two five percent.

The effective interest rate will be higher than the nominal annual interest rate because of compounding, and it will be lower than the inflation rate because of deflation.

7. Fair Interest Rate Definition

The Fair Interest Rate is the rate of interest that’s charged on a loan or investment after taking into account all fees and charges. This type of interest rate takes into account both the nominal annual interest rate and the effective interest rate.

For example, if you have a fair interest rate of eight percent, this means that your nominal annual interest rate is seven point nine five percent, your effective annual interest rate is eight percent, and your fees and charges are two point five percent.

There are always going to be loans that push the boundaries of what’s payable, so you need to be aware of what’s out there and shop around. Let’s say you’re looking for a wedding loan. There’s nothing worse than taking out a loan with a company that you end up paying so much back after fees that you didn’t know were coming.

8. Variable Interest Rate Definition

A Variable Interest rate is an interest rate that can change over time. This type of interest rate is usually tied to a particular index, like the LIBOR or the prime rate.

If you have a variable interest rate, your monthly payments could go up or down depending on how the index changes.

Variable interest rates are common on student loans and credit cards.

How does Interest Rate Calculation Change base on Interest Rate Type?

It changes a lot. Depending on how the interest rate is calculated will determine how much you pay back, and sometimes this difference can be a lot. It’s best to see the difference with the figures side by side. For this section, we’ll imagine you’re taking out a loan of £5,000 with an average 4% interest rate.

The Simple Interest Rate is the rate of interest that’s charged on the original loan amount. This type of interest rate doesn’t take into account any compounding, which means that you’ll only ever pay back the original loan amount plus the interest. The formula looks like this;

£5,000 taken out with a 4% rate for a time period of five years. A = 5000(1 + (0.04 × 5)) = 6000. Therefore, A  equals £6,000.00. Your paid interest will be £1,000.

The Annual Interest Rate is the rate of interest that’s charged on a loan or investment over the course of one year. This type of interest rate takes into account compounding, which means that you’ll pay back more than the original loan amount.

The financial equation is A = P(1 + r/n)nt, where A is what we’re working out, P is the starting figure, r is the interest rate, (or 0.04), the n is your compound (12 months), and t is how long the long is for, in this case, five years.

A = P(1 + r/n)nt

A = 5,000.00(1 + 0.04/12)(12)(5)

A = 5,000.00(1 + 0.003333333)(60)

A = £6,104.98

That means your paid interest will be £1,104.98, depending on the variable rate.

The Effective Interest Rate is the rate of interest that’s actually paid on a loan or investment. This type of interest rate takes into account both compounding and inflation, which means that you’ll pay back more than the original loan amount.

This can feel a little tricky to work out but the formula is basically;

If your rate is 4% compounded monthly then the Effective Annual Interest Rate will be about 7.22%.  If the time period is five years, then the formula would look like this;

First calculating the periodic (yearly) effective rate: i = ( 1 + ( r / m ) )m – 1

i = ( 1 + ( 0.044 / 12 ) )12 – 1 = 0.040742 = 4.0742%

Next calculating the compounded interest rate of i over 5 years: it = (1 + i)t – 1

it = (1 + 0.040742 )5 – 1 =  0.0220997 = 22.0997%

And we would also get it = ( 1 + ( r / m ) )mt – 1 = 22.09%

Finally, the Fair Interest Rate is the rate of interest that’s charged on a loan or investment after taking into account all fees and charges. This type of interest rate takes into account both the nominal annual interest rate and the effective annual interest rate.

You would have to work this out yourself by making sure you’re checking out each loan you’re interested in, working out the fees and charges surrounding each loan, and then comparing the final costs.

This is why having clarity on your loan type is so important. The economic outcomes can be so different, and the fees so much higher or lower than you can realise, especially when taking out a large sum of money, such as you would when acquiring a mortgage. Define your interest type and use an interest rate calculation tool, which can make it easy to work out the figures you’re working with. 

Which loan types are more important for interest rate types and their calculation?

The type of loan you have can also impact the interest rate you pay, as rates differ between different loan types. For example, variable interest rates are common on student loans and credit cards. And as mentioned before, the simple interest rate is the rate of interest that’s charged on the original loan amount.

This means that if you’re taking out a loan for a large sum of money, the simple interest rate is going to be more important than the annual interest rate. But if you’re taking out a loan for a small amount of money, the annual interest rate is going to be more important.

This is because the simple interest rate is based on the original loan amount, while the annual interest rate is based on the current balance of the loan.

It’s also worth noting that the fair interest rate is usually only relevant for investments, not loans.

So, when you’re taking out a loan, the most important interest rate to pay attention to is going to be the annual interest rate. But it’s always good to know all of the different types of interest rates so that you can make informed decisions about your finances.

1.Car Loan Interest Rate Definition and Calculation

When you’re buying a car, the dealership will usually offer you two types of loans: a fixed interest rate loan or a variable interest rate loan.

A fixed interest rate loan is a loan where the interest rate stays the same for the entire life of the loan. This means that your monthly payments will stay the same, and you’ll know exactly how much you’re going to pay back over the life of the loan.

An example of this would be taking out a loan for £5,000.00 over a period of five years at a fixed interest rate of 12%. Your total interest paid would be £1,673.

A variable interest rate loan is a loan where the interest rate can change over time. This means that your monthly payments could go up or down depending on how the interest rate changes.

For example, taking out the same loan of £5,000.00 over a period of five years, but with a variable interest rate of 12%. This would mean that your monthly payments could vary depending on how the interest rate changes. While you pay 12% in the first year, in the second year, you may pay 13%, which means your monthly payments will increase.

The type of loan you choose will impact your monthly payments and the total amount you pay back over the life of the loan.

When you’re choosing a car loan, it’s important to understand the difference between these two types of interest rates. You don’t want to end up with a loan that you can’t afford, so it’s important to do your research and understand what each type of loan offers.

Another type of interest common with car loans is something called an annual percentage rate, or APR. This takes into account the interest rate as well as any fees and charges that you may have to pay.

The APR will be higher than the interest rate, as it includes all of these additional fees. So, when you’re comparing different car loans, be sure to compare the APR rather than just the interest rate.

An example of this, using the £5,000 over five years at 12% loan example, if you’re compounding monthly, you’d be paying back around £6,673.33, and that’s assuming the interest rates stayed the same.

2. Mortgage Interest Rate Definition and Calculation

Mortgage interest rates work in a similar way to car loan interest rates. You can either choose a fixed interest rate, a variable interest rate, or something like a standard variable rate (SVR).

A fixed interest rate mortgage is a mortgage where the interest rate stays the same for the entire life of the loan. This means that your monthly payments will stay the same, and you’ll know exactly how much you’re going to pay back over the life of the loan.

An example of this would be taking out a mortgage for £150,000.00 over a period of 25 years at a fixed interest of 3.5%. This would mean that you’d be paying back £225,358 over the life of the mortgage, in addition to any fees and charges.

A variable interest rate mortgage is a mortgage where the interest rate can change over time. This means that your monthly payments could go up or down depending on how the interest rate changes.

An SVR is a type of variable interest rate mortgage where the lender can change the interest rate at any time. This also means that your monthly payments could go up or down depending on how the interest rate changes.

So, while a fixed interest rate mortgage guarantees that your monthly payments and the amount you pay back over the life of the loan will stay the same, a variable interest rate mortgage or SVR could mean that your monthly payments could increase.

It’s important to remember that, with a variable interest rate mortgage or SVR, your monthly payments could go up as well as down. This means that you need to make sure you can afford the loan if the interest rates do go up.

What are the other Interest Rate related terms’ definitions?

The further you get into the world of interest, the more you’ll come across some rather interesting, if not rather complicated, phrases that can leave you a little stumped. This list is all about helping you find clarity.

  • Interest Rate Floor: An interest rate floor is the minimum interest rate that a lender will charge on a loan. For example, if you have a variable interest rate loan with an interest rate floor of five percent, your interest rate can never go below five percent.
  • An Interest Rate Ceiling: An interest rate ceiling is the maximum interest rate that a lender will charge on a loan. For example, if you have a variable interest rate loan with an interest rate ceiling of ten percent, your interest rate can never go above ten percent.
  • Interest Rate Products: An interest rate product is a type of loan that has a specific interest rate. For example, you could have an interest-only mortgage which would be an interest rate product.
  • Interest Rate Caps: An interest rate cap is the maximum amount that an interest rate can change in a given period of time. For example, if you had an annual percentage rate (APR) interest rate cap of two percent, your APR could never change by more than two percent in a year.
  • Interest Rate Derivative: An interest rate derivative is a financial product that is used to speculate on or hedge against changes in interest rates. For example, you could use an interest rate derivative to protect yourself against a potential increase in interest rates.

What is the difference between interest rate and interest?

At its most basic, the best interest definition is the fee that you pay for borrowing money. Interest rates are simply a way of measuring how much interest you’ll be paying on a loan.

So, if you have a mortgage with an interest rate of five percent, you’ll be paying five percent interest on the amount you’ve borrowed. Conversely, if you have a savings account with an interest rate of two percent, you’ll be earning two percent interest on the money you have saved.

It’s important to remember that interest rates can change over time, which means that the amount of interest you’re paying (or earning) can also change.

So, whether you’re looking to take out a mortgage, saving for the future, or taking out any kind of loan, it’s important to understand what an interest rate is and how it can affect your finances. By understanding the basics of interest rates, you’ll be in a much better position to make informed decisions about your money.