There’s a lot of talk these days about interest rates. When will the Fed (the Federal Reserve Bank) raise the interest rate, and how high will they raise it when it does? Of course, when the Fed raises or lowers an interest rate, it’s only dealing with one in particular – the rate that banks have to pay when they borrow from one another. But every time the Fed does adjust this “prime” rate up or down, it affects the rest of the interest rates in the whole economy.
What is an interest rate, anyway? In its simplest terms, an interest rate is the fee that is paid by a borrower (debtor) for the use of money it has received from a lender (creditor). Most often the interest rate is expressed as a percentage of the amount of the loan (principal), generally for a fixed time period, most often a year. Different interest rates exist because different types of loans impose different levels of risk for the creditor, and different debtors have disparate abilities to be able to pay back a loan in a timely manner.
It would be nice if interest rates were actually that simple. But the truth is, there are several different types of interest rates: real, nominal, effective, annual, etc. The differences between these rates may seem overly technical to the uninformed, but lenders have been taking advantage of the public’s general ignorance of their distinctions for years in order to increase the actual payback on their loans. Here is a brief explanation of the different types of interest rates:
The “nominal interest rate” is fairly straightforward. If the nominal rate on a loan is five percent, a borrower can expect to pay $5 of interest for every $100 borrowed.
The “real interest rate” is slightly more complex, as it factors in inflation, which is the term that describes the devaluation of money over time. The real interest rate measures the lender’s loss over time due to inflation, when his money is no longer in his hands, but is “owned” by the borrower, and he can’t invest it anywhere else. For example, if money is lent at five percent for a year, but the inflation rate is three percent, then the real interest rate on that loan is two percent.
Another type of interest rate is the “effective rate.” This rate takes the power of compounding into account. For example, if a bond pays six percent a year but compounds semiannually, then the interest gained over the first six months is added to the principal. So, while the interest rate remains the same for the second six months, it is paid on the new, higher amount. Therefore a six percent rate on a $100 bond, compounded semiannually, has an effective rate of 6.09 percent.
Finally, there is the “annual percentage rate” (APR), which is expressed as a single percentage number that represents the actual yearly cost of funds over the term of a loan, plus any fees or additional costs associated with the transaction. It will always be higher than the nominal rate.
The chief advantage to knowing the difference between these different rates is that it allows consumers to make better decisions about their loans and investments.