What is an interest rate?
An interest rate is the fee a credit institute charges for their lending activities, expressed as a percentage of capital. An interest rate is generally indicated on an annual basis (known as an annual percentage rate or APR). Loans can involve cash, consumer goods or large goods such as vehicles or buildings.
For loans, the interest rate is applied to the capital – i.e. the loan amount. In other words, it’s the cost of the loan for the borrower and the rate of return for the lender.
When are interest rates applied?
Interest rates are applied to the majority of loan operations. People take out loans in order to purchase houses, fund projects, launch commercial activities and pay for other types of expenses. Companies, meanwhile, request loans to finance capital increases or expand their operations by purchasing assets such as land, buildings, and machinery. Money obtained through loans is paid back in one go by a set date or through regular repayments.
The money to be repaid is usually higher than the amount that was loaned because lenders want compensation for the loss of their ability to use the money during the loan period. The lender could have invested the funds during the period instead of granting a loan – and that investment would have generated income. The difference between the total amount repaid and the original loan amount is the interest charged.
Factors that influence interest rates
Interest rates vary based on:
- measures adopted by the government or central bank in order to achieve their objectives;
- the value of the initial sum loaned;
- the end term of the investment;
- the probability of default established by the lender;
- supply and demand in the market;
- the quantity of guarantees;
Types of interest rates
Nominal interest rate
The nominal annual rate indicates a “pure” interest rate applied to a financial product.
It’s expressed as an annual percentage and is used to calculate the amount of interest due on a loan.
Running costs and other additional costs are not considered.
Effective annual rate
You will definitely have heard of an effective annual interest rate – it’s probably the “most famous” interest rate around. The effective interest rate is an indicator that includes the annual interest rate on the loan plus all other commissions involved in the loan.
E.G. Italian case: In accordance with Bank of Italy regulations on transparency, pursuant to EU Directive 2008/48/CE, as of June 2011, APR is calculated by including any fees paid by the client to a credit broker in return for them getting a loan.
Fixed and variable rates
A fixed interest rate does not change, meaning that its value will stay the same for the entire duration of the loan.
This is, therefore, the opposite of a variable interest rate. When you take out a loan, you’re usually able to choose between a fixed or variable interest rate. The first offers the guarantee of a stable amount over time, while the second offers the chance of saving if interest rates fall – but entails more risk.
Interest rates on savings
Interest rates on savings show the annual interest that the bank is willing to pay to savings account holders – i.e. people who choose to invest their savings in accounts with the bank.
Real interest rate
The real interest rate is the interest you get if you calculate the annual interest rate on a loan taking inflation into account. However, it’s impossible to predict real interest rates, so it’s not a measure that banks use.
European Central Bank rates
Every month, the European Central Bank manages monetary policy by imposing three rates:
- interest rates on main refinancing operations
- interest rates on marginal lending facilities
- interest rates on savings with central banks
Interest rates on main refinancing operations are the benchmark for the cost of the vast majority of financial operations, including loans and funding offered by banks and credit institutes.
The various rates set by the ECB are also known as reference rates, given that they serve as a guide for financial products offered inside the European Monetary Union.
Euribor is a reference rate indicated the average interest date applied to financial transactions in Euros between European banks.
This rate is particularly important for anyone who has opted for a variable-rate loan, as these are index-linked to the value of Euribor.
This is another reference rate that is updated on a daily basis by the European Banking Federation.
Its value is usually used for fixed-rate loans. It serves as the basis upon which a spread is calculated and applied by the credit institute.
How an interest rate on a loan is calculated
There are three key characteristics involved when we apply for a loan:
- the capital being applied for;
- the term of the loan;
- the interest rate.
The mathematical formula used to calculate interest is based on these three variables. Below is the precise data used to calculate interest on a loan:
- Capital: the amount of money requested, which we will set at €10,000 for the purpose of this;
- Interest rate: Nominal annual rate is annual, APR if taken as the overall rate, EAPR if the rate includes additional costs (EAPR or APR is always better than the nominal annual rate); Let’s suppose that we have an APR of 4%, or 0.04 expressed as decimal. Let’s suppose that the rate is fixed, not variable.
- The term of the loan is expressed in years. Let’s suppose that the term of the loan is six years.
The following is an example formula for calculating the interest:
I = C * r * t
where C is the capital obtained through the loan, r is the rate of interest and t is the term: using our example figures, the interest rate is as follows:
I = 10,000 x 0.04 x 6 = €2.400 interest over six years.
This article is mainly focused on the Italian market and on other leading markets. We advise that readers check the data and regulations pertaining to their countries.