Interest Rate Concepts and Calculations

Question 1

Define the stated interest rate?

Answer 1

Annual rate of interest specified in a contract

• Rate in a loan agreement
• Bond coupon rate

Does not take into account compounding effects of frequency rate of payment

Question 2

Define simple interest?

Answer 2

Interest is computed on the original principal balance only

Question 3

Define compound interest?

Answer 3

Interest computed on principle plus accumulated unpaid interest

Question 4

Define the effective interest rate?

Answer 4

Annual interest rate implicit in the relationship

Net cost of borrowing / Net provides

net proceeds received may be less than amount borrowed due to

• Discounting- interest deducted in advance
• Compensating balance required

Example:

• $2,000, 2-year note discounted @ 6%
• Discounted = Interest deducted in advance
• Net procedures: $2000- $240 = $1,760

Effective interest = 240/1760= 13.64/2 = 6.82%

Question 5

What is the annual percentage rate (APR)

Answer 5

Annual percentage rate- Annualize effective inters karate without compounding on a borrowing for a FRACTION of year.

APR = Effective interest rate for a fraction of a year X Number of fractions in a year

Example:

• $2000, 90-day note discounted @ 6%
• Simple interest = 2000 X .06 X (90/360) = $30
• Effective interest rate= $30/$1,970 = 1.52% for 90 days
• Annual Percentage Rate = 1.52 X 4 quarters = 6.08%

Question 6

APR is the legally required basis for interest in the US?

Answer 6

TRUE

Question 7

What is the effective annual percentage rate?

Answer 7

Annual percentage rate with compounding on borrowing for a fraction of year

Question 8

What is negative interest rate?

Answer 8

Interest rate terms under which the owner of funds pays a recipient interest to hold (and possible use) the funds

• Negative interest arrangement, the owner pays another party interest for holding and using the owner’s funds