Simple Interest Rates
What is an interest rate?
You can think of an interest rate in two different ways. It can be viewed as the cost of borrowing money. Or, it can be viewed as the income earned for lending money.
Borrow or Earn Money?
On the other hand, if you deposit, or lend your money to the bank then they will compensate you with additional money, or interest.
Rate = Percentage
The interest rate is the percentage of every dollar that will either be charged or paid to you. If you borrow $100 and the interest rate is 10 percent (10%) per year then you will owe the bank $10 at the end of the year, as well as, the original $100 borrowed.
If you deposit, or lend, $100 to the bank and the interest rate is 5 percent (5%) per year then you will receive $5 at the end of the year, as well as, the original $100.
A Simple Interest Calculation
These are very basic examples of how interest rates work. A very simple interest rate formula can be derived from both examples;
(money borrowed or deposited) x interest rate/100 = interest owed or paid
Using the above examples;
$100 borrowed x 10/100 = $10 interest owed
$100 deposited x 5/100 = $5 interest paid
Note that 10/100 is the same as 0.10, or 10%. And 5/100 is the same as 0.05, or 5%.
So what is the reason for either charging you interest to borrow, or paying you interest to deposit your money?
One way to think of it is that the borrower, or lender, is taking a risk. In other words, the interest rate is the cost of the risk.
For example, if 10 people each borrow $100 at 10% interest per year, then the bank could possibly collect 10 x $10 plus 10 x $100 for a total of $1,100 at end of the year. If one of those people was not a good risk, then the bank would not collect the $100 borrowed plus $10 in interest. In this situation, the bank would have collected $990 in total. In this case the bank has lost money, their risk.
Another risk that the bank is taking is the risk that goods and services will increase during that year. By the time you pay back the original $100 at the end of the year it most likely won't buy as much as it would have at the beginning of the year. The increase in goods and services is better known as inflation.
The same logic applies if you are depositing, or lending, the bank money. You are also taking the same risks. As such, the bank compensates you for that risk and you receive interest in return.
Stay tuned as I build upon this article and go into more depth the next time around.