Types of Interest Rates and how to calculate it
Interest rates are a major part of most financial transactions. For example, if you’re buying a car and decide to finance it with a car loan, you may have an interest rate of 10% or more. While it may seem like a very large amount, that interest rate is actually very low compared to other loans. What you should remember is that the interest rate on this type of loan is based on a fixed amount per month.
When you obtain money, whether it is when you finance your credit card or to buy a home, interest will always be present, which is the cost you must pay to borrow. If you want to understand how to calculate the interest rate, to avoid surprises when you have to pay, we explain it here.
What is the interest rate?
Depending on who asks the question, the approach to the answer varies, although the way to calculate the interest rate is the same.
For the borrower, the interest rate is the cost that must be pay to receive the money. But for the one who lends the money, it would be what he charges for assuming the risk of lending the money and waiting for it to be pay. The same thing happens with savings accounts or investments; the bank pays you a percentage of your money for investing it in that institution.
Interest rates are express in percentages and indicate the balance between risk and possible return in a give time. The interest rate is define by market fluctuations and varies depending on several factors, including supply and demand, the risk assume and others.
Types of rates
In Colombia there are several types of interest rates that can be summarize as follows:
- Fixed Rate, is the easiest interest rate to calculate and once agree, it remains the same for the duration of the loan and will not vary.
- The Variable Rate or Floating Interest Rate is a rate that is update, generally, every month, although sometimes it can be update quarterly. This rate usually uses a reference unit, which can be the DTF or the IPC, to which a certain percentage is add.
- The Real Rate is the one that is usually applied to investments. As its name indicates, this rate refers to the interest generate by an investment discounting the value of inflation at that time.
- Nominal Rate is the one that is capitalize more than once a year.
- The Effective Rate is the one resulting from the application of the Nominal Rate at the end of the contracting period. As the Nominal Interest Rate is compounded in different periods, interest is applied on interest plus capital and so on.
How the interest rate is calculated
To calculate an interest rate in general, you must follow the following steps:
- For a loan, once you have your fixed APR percentage, divide the percentage by 12 to get your monthly interest rate.
- Apply this monthly interest rate to your loan balance.
- For example, if your annual interest rate is 15%, then divide 15 by 12 and you get 1.25% per month.
- If you receive a loan of $10,000 pesos for one year, you should keep in mind that you have to pay $125 pesos per month in interest.
- At the end of the year you will have paid the $10,000 pesos of the loan plus $1,500 of interest.
- For credit cards, calculating the interest rate is more complex. As this usually varies, you must apply the corresponding rate for that month according to the balance owed.
- It is always recommend that you pay more than the minimum fee or your balance will never go down. This, because the interest will be add to the debt of the previous month and will be recalculate on the new principal amount plus interest.
- In the case of mortgage loans, the interest rate varies depending on the bank, the type of housing (whether it is social housing or not), your credit profile and other factors.
- The interests can be with a fixed rate and a fixed installment during the duration of the credit or they can be with variable interest rates, in which case your monthly installments will be different every month.
Interest rates and savings
The same goes for savings and investments. If you are going to place money in installments in the bank, at the end of the established term you will receive your money plus accrued interest.
Normally, when calculating the interest rate, it is usually somewhat higher when you place the money in longer terms. In other types of investments, the interest rate is usually related to the risk, that is, the higher the risk in your investment, the higher the interest rate you will receive. Understanding how the interest rate of your credit card, loan, savings or investment is calculate will help you better organize your finances and your cash flow.