- Types of Interest
Interest refers to the cost of borrowing money or the return earned on investments. When you borrow money, you pay interest to the lender as compensation for getting access to the funds. Conversely, when you invest money, you earn interest or returns on that investment.
Businesses often have surplus funds that they can invest to earn returns.In order to evaluate investment opportunities, it is necessary to understand interest, such as whether it makes sense to invest excess cash in interest-bearing accounts or to invest in assets with an income-generating potential, like bonds and stocks.
Banks assess the creditworthiness and financial stability of the business seeking a loan. This evaluation includes reviewing the business's credit history, financial statements, cash flow, and overall financial health. Businesses with better credit and financial performance generally receive lower interest rates.
Types of Interest
There are several types of interest often associated with different financial instruments and transactions. Here are some common types of interest in business:
Simple interest is calculated on the original principal amount (the initial sum of money borrowed or invested) for a specific period. It is typically used for short-term loans and investments, where interest is applied only to the principal amount.
Compound interest is calculated on the initial principal amount and any previously earned interest. In other words, interest is earned on interest. Long-term loans, investment products, and savings accounts commonly offer compound interest. It can result in exponential growth of savings or debt over time.
Nominal Interest Rate
The nominal interest rate, also known as the stated or annual percentage rate (APR), represents the interest rate without adjusting for inflation or compounding frequency. It is often used to compare interest rates on different financial products, such as loans or savings accounts.
Real Interest Rate
A real interest rate adjusts for inflation, so it gives businesses a better idea of money's actual purchasing power. Businesses and investors use the real interest rate to evaluate the true return on investments after accounting for inflation.
Formulae to Calculate Interest
Simple Interest Formula
Simple interest is calculated based on the original principal amount (P), the interest rate (R), and the time period (T) for which the interest is calculated. The formula is:
Simple Interest (SI) = P * R * T
SI = Simple Interest
P = Principal amount (initial amount)
R = Interest rate (expressed as a decimal)
T = Time (in years)
Compound Interest Formula
There are four factors that compound interest looks at: the initial principal (P), the interest rate (R), how many times interest is compounded per year (n), and how many years the money has been invested (T). The formula is:
A = P * (1 + R/n)^(n*T)
A = Future value or total amount
P = Principal amount
R = Annual interest rate (as a decimal)
n = Number of times interest is compounded per year
T = Time in years
The result, "A," represents the total amount including both the principal and the interest.
Examples of Calculating Interest
A small business in India borrows Rs 1,00,000 from a bank at an annual simple interest rate of 10% for 3 years.
Simple Interest (SI) = P * R * T / 100
SI = (Rs 1,00,000 * 10 * 3) / 100 = Rs 30,000
The total interest paid on the loan would be Rs 30,000.
A company in India invests Rs 5,00,000 in a fixed deposit account with an annual interest rate of 7%, compounded quarterly. Calculate the maturity amount after 2 years.
A = P * (1 + R/n)^(n*T)
A = Rs 5,00,000 * (1 + 0.07/4)^(4*2)
A ≈ Rs 5,74,188.79
The maturity amount after 2 years would be approximately Rs 5,74,188.79.
A company's financial performance can be significantly affected by the type of interest it holds.
A business's ability to manage debt and interest expenses is critically dependent on knowing the principles and the workings of interest.