We often encounter the use of the term interest in the context of financial services. This term refers to fees or rewards that are charged or earned when using financial services such as investments, savings and credit.
However, even though it is familiar, the term interest is often considered the same as the term interest rate. Many people use the word interest rate with the intention of referring to interest and vice versa many use the term interest to replace interest rates. However, the two terms are different and cannot be used interchangeably.
So what are the differences between interest loan and interest rates?
1. The Meaning
Interest in a financial context can refer to fees charged by creditors to debtors. In this case, interest is the responsibility that must be paid by the debtor outside of the responsibility to pay the principal debt.
In addition, interest can also refer to rewards given to customers or investors for lending or investing in an investment product. In this context, interest is a right received by investors or customers.
While the interest rate is the interest rate charged to the debtor when applying for a loan and which is received by investors as a return on the investment they make. You could say that the interest rate is a measure of interest and is usually expressed in percent. In other words, the interest rate is part of the concept of interest which is a parameter for the size of the interest.
2. Type
Another difference is based on the type. Interest generally consists of two types, namely simple interest and compound interest.
#1 Simple Interest: Simple interest is a type of interest that is calculated only based on the initial amount (principal) of the loan or investment. This means that the amount of interest paid or received remains the same each period, regardless of interest paid or received in the previous period.
Example:
If you borrow $1,000 at a simple rate of 5% per year for 3 years, then the interest payable is 5% of $1,000 each year (total interest = $1,000 * 0.05 * 3 years = $150).
#2 Compound Interest: Compound interest is a type of interest that takes advantage of interest that has been paid or received in the previous period. This means the amount of interest paid or received in each period may change as it calculates interest on the amount of the principal plus the previous interest.
Example:
If you borrow $1,000 at 5% compounded annually for 3 years, the first interest will be calculated as simple interest. However, in the second year, interest will be calculated on the amount of the original principal plus the first interest already paid ($1,000 + $50 = $1,050). And so on.
Meanwhile, interest rates in general also occur of two types, namely fixed interest rates and floating interest rates.
#1 Fixed Interest Rate: A fixed interest rate is an interest rate that does not change throughout the credit or deposit period. This means your interest payments will remain the same from the start to the end of the deal period. Fixed interest rates are usually imposed on various types of loans or financial instruments that have a certain period of time, such as mortgage loans, personal loans, deposits and bonds.
For example, you take out a home loan with a fixed interest rate of 4% for 30 years. This means that your interest rate will remain at 4% from the beginning to the end of the 30 year period. If you borrow $200,000, your annual interest payments will remain at 4% of the $200,000 annually for 30 years.
#2 Floating Interest Rates: Floating interest rates are interest rates that can change over time, generally following changes in certain market indicators, such as the benchmark interest rate set by the central bank. Floating interest rates are used to avoid the risk of fixed interest rates and allow interest rates to change according to changing market conditions.
Suppose you have a loan with a floating interest rate linked to a benchmark interest rate (for example, a central bank’s benchmark rate). If the benchmark interest rate goes up, the interest rate on your loan will also go up, so your interest payments increase. Conversely, if the benchmark interest rate falls, the interest rate on your loan will decrease, reducing your interest payments.
Knowing the difference between interest loan and interest rates may not have an impact on our decision making in choosing the financial product we will use. However, by knowing that the two are different concepts, we will no longer be confused when facing information about interest or interest rates. And that means we will be able to easily understand the contents of the information accurately.
