Interest rates
The fluctuation in interest rates has varying impact on both borrower and the lender and the interest rates to be charged on the loans are determined by the risk assumed by the lender and there are various types of interest rate each having its own special characteristics.
There are many types of interest rates associated with different types of financial services, be it credit interest, bank interest, credit card interest or mortgage interest, these are all referred to interest rate on a general note. Interest loan is most commonly used and referred to and thus interest calculator is also available for the calculation of interest on these loans. Interest loans or interest bearing loans are of different categories and have different characteristics, but the most important of all this discussion is that what actually the interest rate is?
What are interest rates?
Interest rates are used to determine the interest o the amount of loan which the borrower pays to the lender as a cost of using the funds provided by the lender. Interest rates are very important element of financial markets and have deep influence on the way financial markets and particularly mortgage markets function. The dramatic increase or decrease in the interest rates has a very significant impact on these markets and their participants. The increase in mortgage interest rates is beneficial for the borrower and bad for the lender because the borrower has access to cheaper source of funds as compared to the mortgage market, but the lender could have earned more if the funds would have been lent at the higher rate. On the other hand, if the mortgage interest rate decreases, the lender is better off because he is getting the income higher than one earned from newly issued mortgages, but it goes against the borrower because he can get the funds from the market at the lower costs as compared to the costs he is presently incurring o the borrowed funds. Under these circumstances, one of the option available to the borrower is that he can prepay the loan and can then borrow at the lower interest from the market. The area that needs consideration here is that the borrower should evaluate the penalties associated with the prepayment of the loan and the costs of striking a new contract. If these cost override the benefits associated with lower interest rate, then it is better not to prepay the loan. Also, if the market is turbulent and the changes in the interest rates are frequent and dramatic, then prepayment is not a good option.
How are mortgage interest rates determined?
The interest rates that are charged to the mortgagor by the mortgage holder depend upon the risk assumed by the mortgage holder. The higher the risk, the higher will be the interest rate and lower risk will be translated in lower interest rates. If the interest rates are expected to be fixed over the life of mortgage, then the cost of borrowing funds are kept substantially high and they increase with the increasing life of the mortgage. This means, the longer the tenure of the loan, the higher will be the interest rate. If the interest rate charged is kept adjustable, then they are associated with some other rates that fluctuate with the market conditions so as to reduce the risks assumed by the lender. These rates are discussed in the coming sections.
Tax treatment of interest by the borrower:
The interest expense paid by the institutional borrowers is tax deductable. This means that the institution can deduct interest paid on the borrowed funds before calculating the taxable income. This tax deductibility makes loans a better financing option as compared to equity financing.
Types of interest rate:
There are various types of interest rates depending upon their specific features. Some of these are listed and discussed as under:
Simple interest rate:
Simple interest rate is applicable only on the amount of principal outstanding. The simple interest can be calculated simply by multiplying the annual simple interest rate with the outstanding principal and the number of years remaining till maturity.
Compounded interest rate:
The compounded interest rate seems very similar to simple interest rate in short term, but as the time period starts becoming longer, the differences become apparent. This happens due to the compounding involved in calculating compound interest as the principal increase over the period of the time, the interest incurred so far is also added to the amount of principal. Thus, the compounded interest is higher than the stated interest on an annual basis and this conclusion is drawn from the comparison of annual compounded interest rate and effective annual interest rate.
Fixed interest rate:
The fixed interest rate is referred to the interest rate determined at the time of issuance of loan and is not changed during the life of the mortgage.
Variable interest rate:
Variable interest rate is the interest rate that is adjusted with time with respect to the changing market conditions. Variable interest rates are generally kept equal to or some percentage points above some other rates. Some of these other rates used to determine the interest rates are given as follows:
- London Interbank Offer Rate (LIBOR) – London Interbank Offer Rate (LIBOR) is the rate that one bank charges to another bank on borrowing money in overnight transactions.
- Prime rate – Prime rate is the rate charged by the banks to their best credit customers and this rate does not change on frequent basis.
- T Bill rate – Treasury bill rate or simply the T bill rates are determined in the T bill auctions and are used in interest rates determination very frequently. The fluctuations in T bill rates have a great influence on the way financial markets work.
There also exists another type of mortgage known as interest only mortgage with its special feature known as interest only. If you want to learn more about these special type of interest rate loan and interest bank, the use of a good search engine will reveal several important facts.