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Guide

All You Need To Know About Interest Rates

Introduction

Lending and borrowing is a type of financial service that allows businesses and individuals to take advantage of the wealth resources available in a sector. The lender who owns enough money but does not have the time or skills to use it to convert it into a profit can grant it to a borrower. 

On the other hand, skilled workers with limited financial resources can use the funds to develop their businesses or expand their operations. The lender can earn income in the form of interest while the borrower gets to enhance their business with the financial supplements.

What are Interest Rates?

The interest rate is a specified percentage of return that the lender gets to claim as a reward for providing financial aid to the borrowing party. Both traditional and cryptocurrency markets have platforms and markets where the lenders and borrowers can come together to form a contract that defines their terms of interest rates. Interest rate is the foundation of a capitalistic economic system. 

Without the presence of an interest rate, the wealthy party would find no benefit in lending their money to the people who are looking for financial support. Some theories suggest that interest rates expand the wealth gap in society. However, interest rates have allowed people of all classes to earn an income from their savings. With cryptocurrency lending platforms, more people are said to get access to financial services and be able to set up lending accounts using their savings.

How does Interest Rate Work?

Any financial contract that includes interest rates signifies borrowing and lending. A lender is a party who has sufficient monetary resources to grant to another party who is seeking financial aid. On the other hand, a borrower is a party that is seeking financial aid and applying for a financial loan in this case. Lenders can be individuals or financial corporations that lend financial resources to an individual to a commercial enterprise. 

The lender agrees to impart the money or other financial resources to a borrowing party in return for a specified percentage of additional revenue from the borrower. The percentage of return is called an interest rate. Depending on the type of lending contract, interest rates can vary and are present in different models. The borrower is required to present a viable business model showcasing products or services that they can use to turn a profit with their acquired loan. Putting money into a bank account or paying insurance premiums are also some types of interest rates.

How to Determine Interest Rates

In traditional finance, the interest rates are determined by a state-level monetary authority like a Central Bank. For example, in the United States of America Federal Reserve has the authority to set the percentage of interest for various types of borrowing and lending contracts under its jurisdiction. The Federal Funds Rate or the Overnight Rate set by Federal Reserve is used by the commercial banks as a reference for borrowing and lending contracts.

On the other hand, regional banks use the Current Interest Rates to determine the Annual Percentage Rate or APR for their account holders. Meanwhile, interest rates for small investments like mortgages, car loans, home equity, student loans, and credit cards are calculated using Prime Rates introduced by the Federal Reserve. Prime Rate is usually 3 percent higher in comparison to the Federal Fund Rates.

Banks and other lending platforms use the risk appetite of a borrower to grant loans. If the credit score of an individual is high, they are more likely to get approved for a financial loan. Credit scores are determined based on the skills, experience, educational background, and past credit payment history of an individual. Loan applicants with a low credit score have to accept borrowed funds with higher interest rates since they pose a higher financial risk for the lender. 

Types of Interest Rates

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Loans are not always drawn out by middle or lower-middle-class individuals. There are a considerable number of big financial organizations in the world that use lending agreements to their advantage. Retail and commercial entities use loans for variable tasks like buying a new house to building a new mega project. Since loans have a wide array of use cases, therefore there are also several types of Interest Rates depending on the type of lending contract. Some of them are mentioned as under:

Fixed

Fixed Interest Rates are considered the ideal option for the borrower. In a fixed interest rate contract, the borrower has to return the money against a fixed percentage within a given time. For example, if Mr John draws a $1000 loan from his bank at a fixed interest rate of 5% for 10 months. Mr. John has to submit $100 to the bank every month with a $10 interest without worrying about any changes in the interest rates. 

Variable

Unlike Fixed Interest Rates, Variable Interest Rates benefit the lender more than the borrowers. In a Variable interest Rate contract, the percentage of interest income keeps increasing over time. Using the example of Mr John once again, who draws a $1000 loan from his bank but this time with a Variable Interest Rate. 

Now, Mr John has to calculate an interest increase of 1% every month. It means that in the first month, Mr John will pay 5% interest, in the second month, he will pay 6% interest, in the third month, he will pay 7% interest, and so on. In some cases, if the interest rates set by the Federal Authority are decreased, the Variable Interest Rate contract can benefit the borrowers.

High

High-Interest Rates signify the period where the interest rates set by a state monetary authority such as Federal Reserve have been hiked. During this period, it becomes more difficult for individuals and businesses to borrow money from banks. Therefore, the demand for loans in the market decreases significantly. In some cases, Interest Rate inflation can lead to deflation in an economical setup. Sometimes, the government adopts policies to hike the interest rates in the region to combat inflationary forces such as Quantitative Tightening.

Low

Low-Interest Rates are the period where interest income percentages become smaller universally. During such duration, it is ideal for businesses and individuals to draw more loans, increasing the demand in the market. The state usually attempts to keep the interest rates lower in an economy. However, a long duration of low-interest rates can lead to inflation. Government agencies can use strategies like Quantitative Easing to lower Interest Rates and encourage more borrowing.

Nominal

The Nominal Interest rate is the determined rate of interest income in a region. For example, Mr John can earn a 5% interest rate annually on his $1000 loan grant to a borrower as per regulations issued by the Central Bank in his country. 5% annual interest, in this case, is the Nominal Interest Rate.

Effective

Effective Interest Rate or Annual Effective Rate (AER) is the comprehensive interest income taking into consideration the compounded interest within a specified investment period. For example, if Mr John has two loans with an Interest Rate of 10% each. His first loan compounds once a year, while his second loan compounds every quarter. Although both loans have a 10% interest rate, the AER for the second loan will be higher.

Real Interest Rate

Real Interest rates can help the borrower to access the difference or changes in their interest payments on account of the recent changes made by a state monetary regulator. For example, if Mr John has drawn a loan at a nominal interest rate of 7%, while the inflation rate in his country is 5%, it means that the real interest rate is 2%. 

Compound interest

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Compounded interest is also known as interest on the interest. The first interest rate in compound interest is applied to the amount that has been borrowed. The second interest rate is applied using the pending loan balance for the next interest payable period. For example, If Mr John has lent a $1000 sum on 5% nominal annual interest. It means that he will earn $1050 at the end of the first year and the end of the second year, and his interest income will increase to $1052.5.

Accrued interest

In Finance, Accrued is a term for a specified income or expense that keeps increasing at regular time intervals. An Accrued Interest is the amount of interest income that has already been realized within a specified date. In other words, Accrued interest is the interest payable that is due but still outstanding or unpaid. For a Lender, it is noted as Accrued Interest revenue in the Debit section of a journal entry, while for a borrower, it is mentioned as Accrued Interest Expense in the Credit section. 

Regular Interest

Regular Interest is the payable amount against a borrowing contract that is realized before the actual loan is returned. Some examples of Regular Interest are bonds and loan interests. 

Annual Percentage Yield

Annual Percentage Yield or APY is the sum or aggregate of the total interest that is calculated at the end of 12 months or calendar year. APY is common with Credit Card Companies and Savings accounts at Banks. Banks use APY rates to attract more consumers to open new accounts in the establishment. Meanwhile, Credit Card Companies use APYs to keep a record of the interest payable for consumers who do not make monthly payments. 

Prime Interest Rate

Prime Interest Rates are the lowest or ideal interest rates that favour the borrowers. Banks reserve Premium Interest Rates for their consumers who maintain a “Triple-A” credit score which postulates that the consumer garners a strong capacity to fulfil their financial commitments. 

Discounted Interest Rate

Discounted Interest Rate is a loaning standard that is set by a Central Bank or any other State-level financial regulatory authority for lending and borrowing contracts on a commercial scale. Discounted Interest Rates are typically short-term loan contracts. Since the DIR lending period can be as short as 24 hours, Banks and other financial institutes can apply for a loan grant to maintain their liquidity level or lending position for one day to prevent any urgent financial crisis.  

Simple Interest Rate

A simple Interest Rate is the aggregate representation of the interest income that is charged by a bank against a loan issue for the comprehensive period of the contract. For example, if Mr John borrowed a $100 auto-loan from his bank with a 5% interest for three years. His Simplest Interest loan would be equal to 100 * 5% * 3 = $15.

Interest Rates in the Traditional Financial Sector

The traditional financial sector requires a considerable amount of factors for issuing a loan. The person who is applying for a loan must have a national registration number, credit history, the presence of a warrantor, legal background, educational certifications, employment history, and many other options. Therefore, it is not wrong to say that drawing a loan from a regional bank or any private traditional financial lending firm is a time-consuming and laborious task. On the other hand, the borrower should also be wary of the terms and conditions of the lending contract that are subject to changes on account of regime change or company policies.  

Interest Rates in the Crypto or Decentralized Financial (DeFi) Sector

Cryptocurrency lending platforms are more lenient in the sense that they are decentralized and employ automated verification protocols such as smart contracts or DAOs. The algorithms on the DeFi lending platforms allow the consumers to instantly qualify for the loan, given that all the predetermined terms of the lending contract are met. Using Peer-to-Peer lending platforms, the investors do not have to go through the rigorous documentation process like the traditional financial service providers.

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However, some platforms require both lenders and borrowers to submit KYC or Know Your Consumer verification process. Additionally, P2P lending platforms can also allow individual borrowers and lenders to create unique lending or borrowing request that allows them to look for the best matches. Crypto Interest Rates are the same as traditional finance; therefore, anyone who has sufficient knowledge can switch gears and earn a good income from Crypto lending platforms. It is worth noting that typically, Interest Rates Revenues are higher on DeFi platforms accounting for the frequent price volatility of digital assets and greater risk factors. 

How to Pick the Best Crypto Lending Platforms?

The cryptocurrency investors who are only getting started in the sector can use the following markers to find the best crypto lending platforms in 2022:

Risk Appetite

Risk Appetite or the track record of a crypto lending platform is crucial information that warrants its reliability. Unfortunately, there are some incidents where the investors put their money into fraudulent DeFi lending platforms that resulted in robberies of their funds. It is best to learn about the risk appetite of a lending platform to ensure that the platform would not file for bankruptcy or get hacked before investing.

Transaction Fees

Transaction Fees can create profits into losses. It is best to compare the transaction fees of different crypto lending platforms and research the factors that directly affect them firsthand.

Interest Rates

Different crypto lending platforms offer different rates of return. With a little market survey and cross-examination, investors can spot the best platforms offering the Highest Interest Rates.

Deposit and Withdrawal Limits

Crypto lenders and borrowers should read and understand the Deposit and Withdrawal limit policies of the platform in detail before making any investment commitments. Some platforms require the investors to start with a conditional minimum deposit limit while many platforms block withdrawals to maintain their liquidity for a given amount of time. 

Contract Duration

Some Crypto lending platforms apply variable lending duration, which means that the time of borrowing can increase depending upon the set policies. Therefore, the crypto investors should ascertain in advance whether the Contract Duration is fixed or variable. 

Collateral

Crypto lending platforms also set a Collateral requirement that means that the borrower is required to deposit a specified amount of cryptocurrencies or stablecoins to qualify for a loan. With the help of comparative analysis, borrowers can find the best platforms that ask for a minimum or zero collateral input. 

Conclusion

The cryptocurrency sector has revolutionized lending and borrowing for many people; anyone with a working internet connection and a smartphone can borrow funds to support their business, buy a house, apply for higher education, etc. With sites like Geekflare.com, cryptocurrency investors can learn about the best DeFi lending platforms in 2022.


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Hassan Mehmood (Saudi Arabia)

Hassan is currently working as a news reporter for Tokenhell. He is a professional content writer with 2 years of experience. He has a degree in journalism.

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