Understanding Interest Rates

Understanding interest rates:

Interest rates are unique in terms of finance and in terms of the economy. Interest rate is the way the people will trade money today vs tomorrow. It has to do with investor’s preferences for the timing of their actual money.

I would prefer to have 100 dollars today to have 100 dollars next year. Everybody would choose 100 dollars today Vs next year. If I am told that I cannot have 100 dollars today than after way to next year then what I want is little extra return because if I had that 100 dollars today I could  invest it  and  earn  some  interest.

Interest rate is basically the way money is traded off between different prices. It is the rate of trade off and has to do with investor’s preferences.

Interest rate is the money that is charged over and above the principle amount.  

Simple interest and compound interest:

One small story to begin with the concept. Once there was a king known for his generosity and keeping his words. There was a notorious and shrewd prisoner awaiting his death sentence was brought in front of the king. The king at that time was playing the game of chess. King asked the prisoner what is your last wish?  Then the prisoner replied “ your majesty I wish to make provision to my family to survive  after my death. Then the king asked “well , tell me what you want”.  Then the prisoner told “ give me the number of grains of rice on the last square of the chess board. If a single rice is kept on the first square and doubled on every neighboring square that is one on the first , two on the second , four on the third ,  eight on the fourth , sixteen  on the fifth and so on until the 64 squares and I shall give it to my family before I die”. Wish granted. Then the king ordered his minister to have the amount of rice calculated and given to the prisoner. But later he was shocked the amount calculated was huge and so large. The king lost his entire kingdom.

Compounding is interest getting added to your capital earning further interest

Simple growth: In simple growth the base on which the investors earn remains the same whereas on compound growth the base increases with the amount earned in every cycle 

Compounding works through 2 tools:

·         The compounding rate

·         The number of compounding cycles.

                 

The compounding rate is the percentage by which the investments rise. Infact even a 2 % can add significant to your wealth.

The compounding cycle is a factor like time. The investment grows by the compounding rate. His period may be one day, one month, one quarter or any other period. Generally one year is the most frequently used compounding period. For compounding to be more effected should be allowed to undergo sufficiently large number of compounding cycles.

Just consider the chess board was 7 by 7 instead of 8 by 8 this would give the prisoner 49 compounding cycles instead of 64. This would reduce the amount but even then a huge amount will be received even with the 49 compounding cycles.