Interest Rate

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.

Related Terms

principal, annual percentage rate, mortgage points