INTEREST RATES

Jan Alfred P. Giron

Joann Kristine Mae O. Roces
What Is an Interest Rate?
The interest rate is the amount a lender charges for the use of
assets expressed as a percentage of the principal. The interest rate
is typically noted on an annual basis known as the annual
percentage rate (APR). The assets borrowed could include cash,
consumer goods, or large assets such as a vehicle or building.

Interest is essentially a rental or leasing charge to the borrower

for the use of an asset. In the case of a large asset, such as a
vehicle or building, the lease rate may serve as the interest rate.
 When the borrower is considered
to be low risk by the lender, the
borrower will usually be charged a
lower interest rate. If the borrower
is considered high risk, the interest
rate that they are charged will be
higher. Risk is typically assessed
when a lender looks at a potential
borrower's credit score.
When Are Interest Rates Applied?

Interest rates apply to most lending or borrowing

transactions. Individuals borrow money to purchase homes,
fund projects, launch or fund businesses, or pay for college
tuition. Businesses take loans to fund capital projects and
expand their operations by purchasing fixed and long-term
assets such as land, buildings, and machinery. Borrowed
money is repaid either in a lump sum by a pre-determined
date or in periodic installments.
The money to be repaid is usually
more than the borrowed amount
since lenders require
compensation for the loss of use of
the money during the loan period.
The lender could have invested the
funds during that period instead of
providing a loan, which would have
generated income from the asset.
The difference between the total
repayment sum and the original
loan is the interest charged. The
interest charged is applied to the
principal amount.
TYPES OF INTEREST RATES
1. SIMPLE INTEREST
Simple interest is a quick and easy method of calculating the
interest charge on a loan. Simple interest is determined by
multiplying the daily interest rate by the principal by the number of
days that elapse between payments.

Simple interest is calculated by multiplying the daily interest rate by

the principal, by the number of days that elapse between payments.
Simple interest benefits consumers who pay their loans on time or
early each month. Auto loans and short-term personal loans are
usually simple interest loans.
SIMPLE INTEREST FORMULA

Simple interest = principal×interest rate×time

EXAMPLE
Sarah deposits $4,000 at a bank at an interest rate of 4.5%
per year. How much interest will she earn at the end of 3
years?

Solution:
Simple Interest = 4,000 × 4.5% × 3 = 540

She earns $540 at the end of 3 years.

2. COMPOUND INTEREST RATES

Compound interest also called interest on interest, is

applied to the principal but also on the accumulated interest
of previous periods. The bank assumes that at the end of
the first year the borrower owes the principal plus interest
for that year.
The bank also assumes that at the end of the second
year, the borrower owes the principal plus the interest for
the first year plus the interest on interest for the first year.
• The interest owed when compounding is higher than the
interest owed using the simple interest method. The
interest is charged monthly on the principal including
accrued interest from the previous months. For shorter
time frames, the calculation of interest will be similar for
both methods. As the lending time increases, however, the
disparity between the two types of interest calculations
grows.
COMPOUND INTEREST RATE FORMULA
EXAMPLE
Problem:
An investment earns 3% compounded monthly. Find the value of an initial
investment of $5,000 after 6 years.

Solution:
Determine what values are given and what values you need to find.

• Earns 3% compounded monthly: the rate is r=0.03 and the number of times
compounded each year is m=12
• Initial investment of $5,000: the initial amount is the principal, P=5000
• 6 years: t=6
• You are trying to find A, the future value (the value after 6
years). Now apply the formula with the known values:

A=P(1+r/n)nt
=5000 (1+0.03/12)12 x 6
=5984.74

• Answer: The value after 6 years will be $5,984.74.

3. FIXED INTEREST RATE
Fixed interest rate is an unchanging rate charged on a
liability such as loans or mortgages. It might be applied
during the entire term of the loan or for just part of the
term, but it remains the same throughout a set of period.

The formula is computed as:

Fixed Interest = Principal x interest rate

Sample Problem:
ABCD Company borrowed a P3,000,000 loan from EFG Bank to acquire
company vehicle with a 5% fixed interest rate annually for 10 years. How
much will be the interest in year 1?

• Computation/Solution:
• Given:
• P = 3,000,000
• r = 5%

• Fixed Interest = Principal x interest rate

• = 3,000,000 x 5%
• = 150,000
4. VARIABLE INTEREST RATE

Variable interest rate is an interest rate on a loan or

security that fluctuates over time because it is based on
an underlying benchmark interest rate or index that
changes periodically.
EXAMPLE
• Ms. ABC, a sole proprietor of ABC Company planned to loan
1,000,000 to buy a parcel of land for the expansion of her
business. She inquire to bank DD which offers 5% fixed interest.
On the other hand, she also received a notification of the loan
from bank EE with 4 %, 5%, 6% and 5.5% interest rates in the
successive years respectively. It has agreed that the principal will
be fixed despite variability of interest rate. Ms. ABC wanted to
know the loan that will give her the lowest possible interest rate.
Determine which bank will give lower interest rates in a span of 4
years.
COMPUTATION
Year 1: Computation:
Given: Interest = Principal x Interest rate
P = 1,000,000 = 1,000,000 x 5%
R = 4% = 50,000

Computation: Year 3
Interest = Principal x Interest rate Given:
= 1,000,000 x 4% P = 1,000,000
= 40,000 R = 6%

Year 2: Computation:
Given: Interest = Principal x Interest rate
P = 1,000,000 = 1,000,000 x 6%
• R = 5% = 60,000
COMPUTATION
Total Accrued Interest:

Year 4:
Year 1 = 40,000
Year 2 = 50,000
Given:
Year 3 = 60,000
P = 1,000,000
Year 4 = 55,000
R = 5.5%
Total = 205,000

Computation:
Interest = Principal x Interest rate
= 1,000,000 x 5.5%
= 55,000
5. Annual Percentage Rate (APR)
Annual Percentage Rate is a useful measure when comparing different loans
and investment because it standardizes the interest rate with reference to time.
The formula is computed as:

APR = Periodic Interest Rate for m Months x 12/m

Sample Problem:

• Mr. G, who must decide to select between two credit cards: Card BP with
2.5% monthly charge and Card BD with 7.1% quarterly charge. What credit
card should Mr. G choose that will accumulate lesser interest?
COMPUTATION
Credit Card BP:
APR = Periodic Interest Rate for m Months x 12/m
= 2.5% X 12/1
= 30%

Credit Card BD:

APR = Periodic Interest Rate for m Months x 12/m
= 7.1% X 12/3
= 28.4%

Therefore, Mr. G must select credit card BD since it has lower Annual Percentage Rate than
credit card BP.
6. Prime Rate
It is reserved for bank’s most qualified customers-those who pose the least
potential of default risk. It is computed as follow:

Prime Rate = Interest Rate - Margin

Sample Problem:

Supposed that the Abala Group of Company, a qualified customer that possess
the least potential for default risk applies for a loan with a 9% interest rate and
with bank additional margin of 4.25%, what will be the prime rate?
Computation
Solution:
Given:
Interest Rate = 9%
Additional Margin = 4.25%

Prime Rate = Interest Rate - Margin

= 9% - 4.25%
= 4.75%
7.Discount Rate
The discount rate refers to the factor used to discount the future cash flows
back to the present days. It is used in the computation of the time value of
money. The formula can be equated as follow:

Discount Rate = (Future Cash Flows/Present Value)1/n-1

Sample Problem:

A future cash flow of 3,000,000 is o be received by the MNL Corporation after 5

years. Calculate the discount rate if the present value of the future cash flows
as to date is assessed to be 2,200,000.
COMPUTATION
Given:
Future Cash Flow = 3,000,000
Present Value = 2,200,000
Number of years = 5 years

Discount Rate = (Future Cash Flows/Present Value)1/n-1

= (3,000,000/2,200,000)1/5-1
= 0.0639953128

Discount Rate = 6.40%

REFERENCES
• https://www.investopedia.com/terms/i/interestrate.asp#:~:t
ext=The%20interest%20rate%20is%20the,as%20a
%20vehicle%20or%20building.

• https://www.investopedia.com/terms/s/simple_interest.asp
#:~:text=Simple%20interest%20is%20a%20quick,days
%20that%20elapse%20between%20payments.