What is the interest rate?

No pie in the sky. If you borrow money, the lender will demand repayment of slightly more than the amount borrowed. The higher portion is interest, calculated as a percentage of the principal.

Similarly, if you deposit your money with a savings or investment service, you will expect to earn a return on interest.

Where have you heard of interest rates?

Whether you are borrowing or depositing, you will hear the term interest rate.

Central banks use interest rates to influence monetary policy (especially to control inflation), and investors pay close attention to their decisions.

What you need to know about interest rates...

Interest rates are divided into different types. The base rate is the rate at which banks borrow from the central bank. Commercial banks are affected by this, but can set their own interest rates on deposits and loans.

The simple or nominal interest rate is based on the principal amount of the loan or deposit:

Simple interest = principal x annual interest rate x years

For example, if you save $1,000 of principal at 7% simple interest for 2 years, you earn a total of $140 in interest, $70 per year.

In the case of compound interest, it is calculated annually as a percentage of the principal plus any accrued interest.

Compound interest = (principal accrued interest) x annual interest rate

So, in the above example, for compound interest, you would earn $70 in interest in the first year and $79.80 in the second year, because the $70 in interest earned in the first year is also used to accrue interest.

Interest rates can be fixed or variable.

When borrowing money, you usually see the interest rate expressed as an annual interest rate (APR) or an effective annual interest rate (EAR). When making a deposit, the interest rate is usually expressed in terms of the annual equivalent rate (AER).