Interest rate

Ciaran Burke

Page written by AI. Reviewed by Ciaran Burke on January 31, 2024.

Definition

‘Interest rate’ refers to the cost of borrowing money or the return earned on an investment, typically expressed as a percentage.

What is an interest rate?

An interest rate is a fundamental concept in finance and economics. When you borrow money, such as taking out a business loan or using a credit card, the interest rate represents the extra amount you must pay back to the lender in addition to the principal amount borrowed. On the other hand, when you invest money in a savings account, bond, or other financial instrument, the interest rate determines how much you’ll earn over time.

In the UK, interest rates are set by the Bank of England’s Monetary Policy Committee (MPC) for the purpose of controlling inflation and promoting economic stability. The MPC adjusts the base interest rate periodically to influence borrowing and spending in the economy.

For instance, if the interest rate is high, borrowing becomes more expensive, which can discourage spending and borrowing. Conversely, when interest rates are low, borrowing becomes cheaper, potentially encouraging people and businesses to borrow and spend more.

So, in summary, the interest rate is a crucial financial parameter that affects borrowing costs and investment returns, and it plays a significant role in the UK’s monetary policy.

Example of interest rate

John, a small business owner, decides to expand his business and needs financial assistance. He approaches ABC Bank for a business loan, and applies for a loan of £50,000 to fund his business expansion

ABC Bank, after evaluating John’s creditworthiness and the business plan, offers him a loan at an annual interest rate of 6% and John will repay the loan amount plus interest rates over a period of 3 years.

Interest = Loan amount x Interest rate = £50,000 x 0.06 = £3,000

Total repayment = Loan amount + Interest rate = £50,000 = £3,000 = £53,000

In this example, the interest rate of 6% represents the cost of borrowing for John’s business loan. It determines the amount of interest he will pay annually on the loan amount.

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