
The cost of borrowing money or the rate of return earned on lending money, expressed as an annual rate. Interest rates can be calculated as simple, compounded or effective.
The simple interest rate is sometimes referred to as the "stated" interest rate. It is the amount of interest paid at the end of the loan term divided by the loan amount. For instance, $100 in interest on a oneyear loan of $1,000 paid at the end of the term equals a simple interest rate of 10 percent.
The compounded interest rate is determined by the frequency of interest payments during a loan or deposit term. Consider the same oneyear loan of $1,000, with compounded interest paid in equal intervals over the term. The $100 in interest is made in four payments of $25, once every three months. The interest payments can be reinvested by the lender sooner, allowing him to earn more interest. The same oneyear loan of $1,000, compounded four times a year, equals a compounded rate of 10.38 percent. If compounded daily, the compounded interest rate increases to 10.52 percent. For depositors, this compounding produces the annual percentage yield (APY).
The effective interest rate is also called the annual percentage rate (APR). It measures the true cost of borrowing. The effective interest rate includes any fees or prepaid interest paid to obtain a loan. For instance, if a borrower pays $50 in closing costs to obtain the same oneyear loan of $1,000, the effective rate will be higher than the stated or compounded interest rate. This is because the borrower is repaying a $1,000 loan but only receiving net proceeds of $950. 