The concept of interest – charging money for access to money – is older than money itself. The first forms of interest, found in ancient Babylonian texts from around 2000 BC, set the maximum rate for wheat at 33.3% p.a. If you borrowed three bags of wheat from a farmer one year, you’d need to pay four bags back the next.
Fast forward to today, and interest rates play a critical part in most of our lives. Sometimes we’re the beneficiaries, seeing a few extra dollars debited into our savings accounts at the end of a month. More often we’re the borrowers who are charged interest as we slowly pay the principal on a loan.
But what is an interest rate exactly? And how does an interest rate work? Read on to find out.
What is an interest rate?
Let’s begin with a simple, four-word interest rate definition: the cost of debt.
When a person wants to buy a house or a business wants to grow, but they don’t have the cash to do so, they’ll go to a lender and apply for a loan. While banks are the most common form of lender, there are many others, such as credit unions, building societies and mutuals, credit card companies and government agencies.
Interest is what a lender charges a borrower to access the money they need, either in the form of a loan (like a business loan, personal loan or mortgage) or a line of credit (like a credit card.) You’ll perhaps be most familiar with interest rates as a thing you need to pay, perhaps as part of your home loan or a personal loan, but if you have a savings account you might earn off interest rates too: putting money in a savings accounts allows a bank to lend those funds to other people, and they’ll pay you a (relatively low) interest rate for the opportunity to do so, usually represented by a few extra dollars being debited into your account at the end of every month.
A more complete interest rate definition might therefore be ‘the changeable rate, represented as a percentage, that is used to calculate the amount of interest a borrower owes.’
How do interest rates work?
Interest is usually calculated based on an interest rate as a percentage of the unpaid ‘principal’ (the amount initially borrowed.) The borrower still needs to pay down the principal, which represents a separate charge.
Perhaps the thing that causes the most confusion around interest rates is the fact that they change. Sure, some loans allow you to choose a ‘fixed’ interest rate, but this only holds the rate in place for a certain period of time – usually between one and five years – and usually these rates will initially be higher than a variable equivalent. In truth all loans feature variable interest rates, because that’s just how interest rates work – they vary.
Why do interest rates change?
If we zoom right out, interest rates change based on two forces: supply and demand.
When supply of credit outpaces demand, interest rates decrease, and when demand for credit outpaces supply, interest rates increase. If you defer a repayment, you’re denying your lender the ability to loan that money out, thereby decreasing the amount of available credit in the market. Less supply leads to greater demand, which eventually leads to higher interest rates if enough borrowers do the same.
Zooming in a little bit, there are a number of tangible, real-world factors that directly affect interest rates:
If inflation is high, lenders increase interest rates to cover the devaluation of the currency. It’s the job of a country’s central bank – in our case The Reserve Bank of Australia (RBA) – to keep inflation at a reasonable and sustainable level, usually 2-3%.
2. The cash rate
The main way the RBA controls inflation and directly affects Australia’s interest rates is by setting the rate charged on unsecured overnight loans between Australia’s banks. This is called the ‘cash rate’, and a wealth of factors go into calculating it. The cash rate is reviewed 11 times every year on the first Tuesday of every month except January. When this rate is low, interest rates are low, and when this rate is high, interest rates are high.
3. Levels of risk
Lending to a business or individual with a bad credit history is riskier than lending to a business or individual with a good credit history. Offering an unsecured loan is riskier than offering a secured loan. The greater the risk for the lender, the greater the interest rate they’ll apply. This is why relatively safe, large and long-term loans like business loans and mortgages generally have a far lower interest rate than riskier, smaller, shorter-term payday loans.
4. The lender and loan
Some lenders focus on long-term, relatively safe loans. Others focus on short-term, high-risk loans. While market forces will ensure rates are competitive – a lender won’t attract customers if they aren’t – the exact rate they charge is largely up to them (provided they work within regulatory frameworks.)
How are interest rates calculated?
There are a number of different interest rate calculations and charging methods, but perhaps the best place to start is with simple interest.
The formula for simple interest is:
(Principal x Rate x Time)/100 = The Amount of Simple Interest
Imagine you took out a loan of $10,000, at an interest rate of 5%, for a loan term of one year. If we plug those numbers into our formula, we get:
(10,000 x 5 x 1)/100 = $500
Over the course of the loan, you’ll pay $500 in interest. If we extend the loan period out, we find that an extra $500 must be paid for every year we add.
The 4 main types of interest
While simple interest is a great introduction to the concept of interest rates, you’ll struggle to find a loan labelled ‘simple interest’. Instead you’ll see interest most commonly applied in the following four ways.
1. Fixed interest
Fixed interest can be thought of as a real-world version of simple interest. This type of interest sees the rate fixed in place for a certain period of time, allowing a borrower to easily calculate what they’ll be paying. The added security means fixed rates are generally set higher than variable equivalents (which we’ll discuss next.)
While a fixed interest rate is almost always calculated on an annual or ‘per annum’ (p.a.) basis, most of the time the interest is charged out monthly. In the case of fixed interest, finding the monthly charge is a simple matter of dividing the total yearly amount by 12. Using the example above, the $500 of annual interest would be split into monthly instalments of $41.67.
2. Variable interest
Variable interest does what it says on the packet. This form of interest follows the trends of the cash rate set by the RBA. If the cash rate goes up, you’ll pay more interest. If the cash rate goes down, you’ll pay less.
Variable rates allow lenders to better manage risk and ensure a borrower isn’t paying less than the market interest rate on their loan. From the borrower’s side, choosing a variable interest rate over a fixed interest rate is a calculated risk. You’ll usually enjoy a lower initial rate, although there’s no guarantee it’ll stay that way. At the same time, if the cash rate falls, you could save serious money.
3. Compound interest
Compound interest is the interest charged on interest… which might sound confusing, so let’s take a look at an example.
Imagine you have $100 in a bank account, and it earns 5% interest every year. At the end of the first year, your balance jumps to $105. At the end of your second year, however, your balance doesn’t jump to $110, it jumps to $110.25. Why? You earn 5%, or $0.25, on the extra $5 you were given last year.
For borrowers, this means that you’ll pay a little more on a compounded loan than you will on a non-compounded loan. Depending on the loan or the line of credit, interest might be compounded daily, monthly or yearly.
4. Annual percentage rate (APR)
APR can perhaps be seen as the opposite of simple interest – it’s an interest calculation that takes every single factor into account, including fees, charges, compound interest and the principal, to describe the true cost of your loan.
You can follow these steps to find out your APR:
Add together all the fees, charges and interest paid over the duration of your loan.
Divide this amount by the total amount of the loan.
Divide the resulting figure by the total number of days in the loan term.
Multiply by 365 to find the annual rate.
Multiply by 100 to convert the annual rate into a percentage.
APR is a useful measure for credit cards, as it takes into account their fees, charges, and regularly compounded interest. APR can also help you to figure out which of two long-term loans might be better value.
Business Loan A has an interest rate of 4.5% with zero fees. Business Loan B has an interest rate of 4% with $4000 in upfront fees. Both are compounded monthly. By using the formula above, we can figure out that the APR of Business Loan B is 4.4%, making it a slightly better deal than Business Loan A in the long run, despite the higher upfront cost.
Advantages and disadvantages of interest rates
What are the good and the bad of interest rates, both for borrowers and lenders?
The advantages of interest rates
Interest rates allow lenders to make money off money. By offering a mix of fixed and variable rates, lenders can safely offer loans to those who need them, and can create a good business while they do it.
Interest rates grant borrowers the ability to access the cash they need, when they need it. Between a wealth of different loans, lines of credit, rates and terms, there’s a funding option to suit every need, and by getting to choose between a fixed and variable rate, a borrower is given some control over the process.
The disadvantages of interest rates
For lenders, the main disadvantage of interest rates is a lack of control. Largely set by the RBA and market forces, lenders can find themselves in trouble if interest rates dip and cut their profits, or interest rates increase and cause borrowers to default on loans.
For borrowers, interest rates can be a very confusing subject, particularly when talking compounding interest and APR, which can lead to people paying far more than they might have expected to. Then there are the uncontrollable market forces mentioned above: if you’re hit with a higher interest rate and default on your loan, you may face financial consequences. Finally, there are the uncontrollable forces beyond the finance market – global pandemics or anything else that causes a dip in business can lead to loan repayments getting away from you.
Square Loans: A business loan without the interest rate
Given the risks associated with interest rates, why choose a loan with an interest rate at all? “Because that’s the only type of loan there is,” you might answer, but thanks to Square, you’d be wrong.
Square Loans represent a brand new way for businesses to secure finance. Available to Square sellers, they form a simpler and more affordable borrowing option; one designed to align with the natural variations that occur in the cash flow of a normal business, but without being subject to the variations of the economy and financial markets.
Rather than needing to pay back a certain amount every month, calculated by an endlessly complex formula, Square Loans instead use a single, simple and 100% transparent loan fee, which is paid off by using a percentage of your daily takings. Having a slow day?? No problem! With Square Loans, your repayments on a slow day will be smaller than on a big day.
No interest, no credit checks, no collateral for loans under $75K – if you’re looking for a better way to finance your growing business, you’ve found it.
This article is only for educational purposes and does not constitute legal, financial or tax advice. Make sure you consult a professional regarding your unique business needs.