Interest

Interest is the cost of the use of money over time.

The interest rate is the percentage fee received or paid by individuals or organizations when they lend or borrow money. The formula for calculating interest in Principle x Rate x Time, or I=prt. Principle is the amount borrowed or still outstanding, Rate is the interest rate of the loan expressed as an annual amount and time is normally a year, or fraction thereof.

For example, if you borrow $10,000 for your business, then you have to pay interest (say 5%) for using that money. If the loan was for one year the interest payable would be $10,000 x .05 x 1 = $500. If, however, half the loan was repaid in six months, the interest payable for the year would be:

(10,000 x .05 x 6/12) + (5,000 x .05 x 6/12) = 375 for the year.

Interest rates have three main components:

• inflation
• risk
• true cost of money

Any interest rate must be at least the rate of inflation, or the money will be worth less when it is repaid than when it was lent.

Borrowers who are perceived to be a higher risk will be charged a higher interest rate. This allows the lender to recoup his losses from the higher risk borrowers who default via the excess received from those who don't.

The final component is the true cost of money. This is more theoretical then practical. However, risk free debt instruments during periods of no inflation often have a rate of 3%.

There are many different interest rates, but the benchmark interest rate—or overnight target rate—is set by the Central Bank of a nation typically. A change or expected change in this rate will lead to changes in other interest rates.