What types of Interest Rates are there and how are they calculated?
The interest rate is the percentage a lender charges a borrower for the use of borrowed money or assets. This percentage is applied to the principal — the amount that was lent.
Interest rate
The interest rate is the percentage that a lender charges a borrower for the use of borrowed money or assets. This percentage is applied to the principal, which is the amount lent. Generally, the interest rate on a loan is expressed on an annual basis and is known as APR (Annual Percentage Rate) — in Mexico, CAT (Total Annual Cost).
An interest rate can also apply to a savings account or a certificate of deposit (CD). In this case, a bank or credit union pays a percentage on the deposited funds to the account holder. This percentage is called the Annual Yield — in Mexico, GAT (Total Annual Yield) — and reflects the interest earned in these deposit accounts.
Interest rate basics
The interest rate is the charge a lender adds to the borrowed principal for the use of the assets.
Interest rates also apply to savings accounts and certificates of deposit, where the account holder earns interest.
Most mortgages use simple interest, but some loans apply compound interest, which is also charged on accumulated interest.
Borrowers considered low-risk by lenders generally receive lower interest rates. High-risk loans tend to have higher interest rates.
GAT refers to the interest earned on savings accounts or certificates of deposit, which is calculated with compound interest.
How do interest rates work?
Interest can be understood as the cost of using someone else’s money or assets. This applies to both cash and consumer goods, vehicles, or property. In essence, interest rates reflect the “cost of money”: higher rates make borrowing more expensive.
Interest rates apply to most lending or credit transactions. For example, people take out loans to buy homes, finance projects, or pay college tuition. Companies, on the other hand, take out business credit to expand, acquire fixed assets, or finance large projects.
Interest on a loan is calculated on the principal. For the borrower, the interest rate is the cost of debt; for the lender, it’s their return. Generally, the total amount to be repaid is greater than the original loan, since the lender needs to be compensated for not having used that money in another way during the loan period.
Borrowers considered low-risk by the lender usually receive lower interest rates. On the other hand, those considered high-risk face higher rates, which increase the total cost of the loan.
Simple interest
Suppose you take out a loan of $300,000 with a simple interest rate of 20%. This means you’ll pay the bank the borrowed amount plus 20% of $300,000 each year — that is, $300,000 + $60,000 = $360,000.
Simple interest is calculated using the formula:
Simple.Interest = ((principal) × (interest.rate)) × (time)
If this were a 3-year simple credit, the calculation would be:
Simple.Interest = ((300,000) × (0.2)) × (3) = 180,000
This implies that, in total, you would have paid $180,000 in interest over 3 years.
Compound interest
Compound interest, also known as “interest on interest,” is applied to both the principal and the interest accumulated in previous periods. Unlike simple interest, which only applies to the principal, compound interest progressively increases what you owe.
For example, on a $300,000 loan over 3 years at a 20% compound interest rate, you’d end up paying approximately $218,400 in interest.
The formula to calculate compound interest is:
Compound.Interest = principal × ((1 + interest.rate)ⁿ − 1)
Where n is the number of compounding periods.
The cost of debt for the borrower
While for the lender, interest represents a gain, for the borrower it’s a cost. Companies often compare the cost of financing through debt with the cost of financing through equity to determine the most economical option.
CAT vs. GAT
Interest rates on consumer loans are generally expressed as Total Annual Cost (CAT), which reflects the return the lender requires for lending the money.
On the other hand, Total Annual Yield (GAT) applies to savings accounts or certificates of deposit, and takes compound interest into account.
The main difference is that CAT is the percentage you’ll pay on a credit or loan, including fees, VAT, insurance, and additional expenses. On the contrary, the Total Annual Yield is the return you’ll receive from an investment.
How are interest rates determined?
The interest rates that financial institutions charge are determined by several factors, including the economy. A country’s central bank sets the interest rates that banks then use to determine the range of CAT they offer.
When interest rates are high, the cost of debt rises, which discourages people from borrowing and reduces consumer demand. This usually happens in high-inflation contexts, where central banks raise rates to control inflation.
On the other hand, in a low-rate environment, loans are more accessible and people and companies tend to spend more, which stimulates the economy.
Conclusion
Interest rates are a crucial component in any financial decision, whether you’re taking out a loan or investing in savings accounts. Understanding the difference between simple and compound interest, as well as between CAT and GAT, lets you make more informed decisions and avoid unnecessary costs. If you’re looking for an agile and transparent alternative to get liquidity without the complications of traditional interest rates, KredFeed offers digital factoring solutions that adapt to the needs of your SME. Discover more in our blog and take the next step toward better financial health.
Discover the options KredFeed has for you: www.kredfeed.com/#beneficios
