What are interest rates?

Image that shows interest rates

We’ll start by breaking down simple concepts that you will see all the time when it comes to money management. First up are interest rates. Interest rates are the percentage of X amount the money you owe to a lender which increases on a daily/monthly/yearly basis. It is the additional amount of money you pay ON TOP of the total amount that is due.

So why is it important to look at interest rates?

Interest is essentially a charge to the borrower for the use of an asset. Assets borrowed can include cash, consumer goods, vehicles, and property. Because of this, an interest rate can be thought of as the “cost of money” – higher interest rates make borrowing the same amount of money more expensive.

Let’s look at a real-world example

Say you are looking to buy a car for SR 50,000 and decide to go to the bank to get a loan. The bank will enter an agreement with you that they will pay this total (SR 50,000) to the car dealership, in exchange you will have to pay the bank the amount owed (or “principal”) + interest rate back in the set time frame. This can be done in installments.

Now, this is key. Basically, the bank needs to make a profit, and this is where interest rates come in. Interest rates are typically always applied to most lending/borrowing assets. Through interest rates, the total amount owed to the bank (aka “principal”) at the end is more than what the bank paid to the dealership.

Back to the example.

If you take out an SR 50,000 loan from the bank and the loan agreement stipulates that the interest rate on the loan is 3% simple interest during 3 years, this means that you will have to pay the bank the original loan amount + the interest rate.

Interest rate formula

You can use this formula to calculate the total amount you will owe the bank after 3 years: Amount = Principal (1 + rt)

A = SR 50,000 (1+( 0.03 x 3))

   =      50,000 (1 + 0.9)

   =      50,000 (1.09)

A =      54,500

The example above was calculated based on the annual simple interest formula, which is:

Simple interest = principal X interest rate X time

You will have to pay SR 4,500 in interest at the end of the year to the bank on the loan, assuming it was a 3-year lending agreement:

Simple interest = SR 50,000 X 3% X 3 = SR 4,500  

Understanding interest rates is important in our day-to-day lives. Credit cards, for example, typically have very high-interest rates. It is necessary to understand this as it can impact your overall financial goals.

If you want to learn more, we have a blog post on compound interest!

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