Interest Rates 101: Know Your Terms
Whether your financial situation is solid or you're vulnerable to market fluctuations, the importance of understanding interest and its connection to your financial wellbeing is crucial.
Let's start with some basic terminology that will help you understand how interest affects your life.
1. Principal is the base amount of money that you're either borrowing or investing.
2. Term refers to the length of your loan or investment.
3. Interest is the amount that you're charged for borrowing money or that you're given for keeping cash in your accounts.
There are two types of interest: simple and compound.
4. Simple interest is charged only on the original principal amount.
For example, if you have P1,000 with a 5% annual interest rate for 3 years, you'll earn P50 (5% of 1000) of interest per year, for a total of P1,150.
5. Compound interest is charged on both the original principal amount, and any interest previously accrued. Plainly put, it's interest on interest.
For example, let's look at that same P1,000 with a 5% annual interest rate for 3 years with
compound interest: your principal would earn P50 interest in the first year, but in the
second year, you'd earn interest on the new total of P1,050, which would be P52.50, then
P55.13 in the third year, for a total of P1157.63.
Interest rates & annual percentage rate (APR): the interest that you earn (or that you're charged) is based on the APR. Again, there are different ways of calculating the APR, which impacts the actual interest rate.
6. Nominal interest rate is the most basic type of interest rate. It's a flat interest rate paid on a
For example, if the nominal rate on P1,000 is 5%, the total interest will be P50. The nominal interest rate is directly connected to simple interest, in that it's the flat rate charged for borrowing or lending money.
7. Real interest rate is the nominal rate, adjusted for inflation.
For example, if the nominal interest rate is 5%, and the inflation rate is 2%, your real interest rate is 3%. So on that P1,000, the real interest earned would be P30.
8. Effective interest rate is the rate with compounding taken into account.
For example, if the interest rate on P1,000 is 5% per year, compounded semi-annually (twice per year), you'd earn P25 after the first 6 months, then P25.63 in the second 6 months of the year. In that case, the nominal interest rate is 5%, and the effective rate is 5.06%.
9. Prime: prime is the base interest rate that banks and lenders use to set their interest rates.
Interest rates can be incredibly boring, but incredibly important too. That’s why it’s best to understand these things, and know how it will impact your life. Speak to a Manulife Advisor to know more about interest rates and how it could impact your financial well-being.