Understanding the basics of interest rates and how they work will help you work out how much a loan is going to cost or how much you will earn on a deposit.
Interest rate are quoted as a percentage and refer to a specific period of time over which they are applied to borrowed or deposited amounts.
It is worth distinguishing interest from the interest rate. The interest rate is a percentage, whereas the interest is the result of applying this percentage to the principal over the corresponding period.
If the interest rate on a loan is 3% per annum, the bank will obtain €3 in interest for each €100 lends for a year.
If the interest rate on a €100 deposit is an annual rate of 4% but only paid for one quarter, at the end of the quarter you will receive interest of €1. This is the same as a quarterly 1% interest rate.
Types of interest rates
There are various types of interest rates:
Simple interest is not added to the principal.
Compound interest is added to the principal so interest so that it subsequently earns interest.
For instance, a €1,000 loan for repayment after two years and an annual interest rate of 3%:
- Simple interest. Interest of €30 is settled at the end of each year.
- Compound interest. The first year´s interest is added to the principal:
- Interest in the first year: 3% on €1,000 = €30
- Interest in the second year: 3% on €1,030 = €30.9
- Total interest to be paid at the end of the second year: €30+€30.9 = €60.9
When the interest calculation period and the interest settlement period are the same, a nominal rate of interest is being used.
When the interest calculation period and the interest settlement period are different, the effective interest rate is needed. This takes the date on which interest and principal payments take place into account in the interest calculation.
The effective interest rate is based on the compounding of interest. You can find it using our calculator.
Fixed rate: the same interest rate is applied over the entire duration of the loan or deposit.
Variable rate: the interest rate applied changes over the lifetime of the loan or deposit and it is usually quoted as a benchmark rate plus a percentage or spread.
Mixed-rate transactions are also common. For instance, loans which an initial fixed-rate period followed by a variable rate for the rest of the term; or a deposit in which a proportion of the transaction is subject to a fixed rate, and the rest to a variable rate.