Interest rates are an essential variable in economics. They interest financial planners because they provide clues about the economy’s strength.
They also are essential for figuring out how much it costs to borrow money for business owners. For example, if you are interested in getting a small business loan, or any other type of loan, you need to understand how interest can affect the cost of borrowing money.
In simple terms, the higher the interest rate you are charged, the more you will pay to borrow money. The longer the timeframe over which you pay off the loan, the greater the amount you will pay in total, even if the monthly payments are lower.
Some important terms
Here are some definitions to be aware of:
Principal: the amount of credit offered
Interest rate: expressed as an annual percentage, it is the cost of borrowing money.
APR: the annual cost of a loan which includes fees and any additional costs.
How are interest rates determined?
Three institutions determine interest rates. These are:
The Federal Reserve: This government agency is in charge of the benchmark federal funds rate. This is the short-term interest rate charged by the government to banks and other financial institutions.
U.S. Treasury: U.S. Treasury bonds and notes are a fixed-income in the form of investment. Demand for these products impacts the interest charged for loans and credit.
Banking sector: The interest rates banks provide for savings and that they charge for loans must thread the needle between maximizing profits and attracting borrowers. This usually means most banks are limited to a narrow range.
Types of Interest
There are two types of interest, simple and compound. First, how do you calculate the total interest you will pay?
Simple interest: To calculate the total amount of interest you will pay if you are being charged simple interest, you start by multiplying the amount of the loan by the interest rate for the amount charged per year. This is then multiplied by the number of years the loan is in effect.
Compound interest: To understand the total amount of interest paid when compound interest is being charged is more complex. Typically the amount due is calculated every month. The amount remaining on loan is multiplied by the interest rate. Each month, the principal is modified, and the new amount paid as interest is calculated.
Compound interest is used for mortgages, auto loans, and credit cards. Because interest owed can snowball under this scenario, it’s a good idea to pay off credit cards as quickly as possible.
If you are a small business owner considering borrowing money, consider an SBA loan. sba loan rates tend to be the most attractive for small businesses, according to Lantern by SoFi.
You can learn more about SBA loans and other types of loans on their website.
Lantern at SoFi is an online marketplace that allows small businesses to find information about loans. They can use the site to compare interest rates and other options to determine which loans might be the best for them.
