Prime Loan Interest Rate

For many people, the concept of “interest rates” is so obvious and self-explanatory–but really, does everyone fully understand what interest rates are, where they originate from, and how they are applied in concrete economic settings? To put it simply and give a universal definition applying to all types of interest rates, interest is the price you pay for borrowing money, and therefore the profit the lender earns for their willingness to defer immediate use of the same funds. It is most often expressed in a percentage rate for a year, generally known as “annual percentage rate” or APR.

Interest is charged most every time you borrow money from any person or institution for any purpose (except perhaps friends and family, although not even they may be so generous since they also pay a price in their giving up the use of those funds for a given time). All interest rates can be divided into two general categories: nominal interest rates and real interest rates. A nominal interest rate, as the name suggests, is the rate on paper, not taking into account the rate of inflation for the period of the loan. For example, if I lend you $1,000 for a year with an APR of 10%, you will owe me $100 in interest, for a total of $1,100 — that is the nominal interest. But what if the purchasing power of money was weakened due to inflation, and my $1,100 will only buy me what $1,000 would have a year earlier? The real interest rate, in this case, was zero, because inflation reduced my profit. Many credit card issuers, mortgage lenders, and other creditors offer interest rates that are adjustable to the rate of inflation so that they do not lose their original projected profit from the transaction.

Interest is often “compounded” as well. The idea of compound interest means that the original interest is added to the principal (i.e., the original amount borrowed), and subsequent interest calculated accordingly. Back to the simple $1,000 with 10% APR example, if interest after a year is $100 and it is compounded, the next year the interest will be $110, based on the principal of $1,100. The difference between nominal APR and effective APR is that the latter includes the fee and the compound interest rate rather than just the simple interest.

For more information about specific interest rates for various types of lenders and interest on savings, such as CDs, check out the relevant tabs above!