Chapter 1. Interest rates - types and terminology

Interest can be a charge or an income, depending on whether you are borrowing money or lending/investing money. It is stated as a percentage over a specific period of time.

How to

There are many types and forms of interest.  It is critical you know the terminology.  Here are the most commonly used terms:

Simple interest

• • Simple interest is computed on the original amount as the return on that principal for one time period
    • Example:
      • $1,000 invested for ten (10) years at 5% simple interest will yield $1,500 by the end of ten years. 1000 + (1,000 x 0.05 x10) = $1,500

Compound interest

• • Compound interest is computed on the original amount as the return on that principal plus all unpaid interest accumulated to date
  • Compound interest is always assumed in TVM problems
    • Example:
      • $1,000 invested for ten (10) years at 5% interest compounded quarterly (4 times a year) will yield $1,643.62 by the end of ten years. 1000 + ((1,000 x(1.0125)40) = $1,643.62 This is much larger than the $1,500 obtained through the simple interest calculation
  • This is a powerful concept that means money can grow at an exponential rate depending on how often interest is credited to the account
  • Once interest is credited, it becomes in effect principal
  • It is very critical you understand the compounding frequency of your investment prior to committing your money to it

Fixed interest rate

• • Fixed interest rate is a straight forward rate that remains constant during the life of the loan or investment

Variable interest rate

• • Variable interest rate changes during the life of the loan and is usually tied to the prime rate
  • It can go up or down depending on the prime rate set forth by the Federal Reserve

Mixed interest rate

• • Mixed interest rate changes from fixed to variable or from variable to fixed
  • It has some merits depending on your situation, but it is not a rate you would want to choose for a long-term investment or debt

Practice