What is Interest Rate? What Investors Need to Understand

Have you ever wondered why your loan has additional costs, or why your savings deposit increases over time? The answer lies in an important financial concept - interest rate. This is not just a number on paper, but a driving force in every financial decision you make.

What is Interest Rate - Basic Concept

Interest rates can be simply understood as the price of money. When you borrow money from a bank or use a credit card, you not only have to pay back the original amount but also an additional amount calculated as a percentage. Conversely, when you deposit money into a savings account or invest, you will receive returns based on that interest rate.

In other words, interest is the cost of using money or the reward you receive when you allow others to use your money.

Two Interest Calculation Methods You Need to Know

Depending on the type of contract, interest is calculated using two different methods:

Simple Interest - Simple Calculation Method

This type of interest is calculated only on the initial principal amount. For example, if you borrow 100 million dong at an interest rate of 10% per year, you will pay 10 million dong in interest each year, regardless of how long. Simple interest is usually applied to short-term loans or certain types of bonds.

Compound Interest - Accumulation Effect

This is the “wonder” of finance. Compound interest is calculated not only on the principal but also on the interest that has been accumulated from previous periods. This means your money grows exponentially, not linearly. If you deposit money into a savings account with compound interest, each period you will earn interest on the previous interest - a continuous accumulation cycle.

Why Interest Rate Is Important For You?

Impact on Borrowing Costs

High interest rates mean that the overall cost of borrowing money will be higher. If you borrow 500 million to buy a house at an interest rate of 5% or 8%, the difference can amount to hundreds of millions of dong over the loan period.

Impact on Savings and Investment

Conversely, high interest rates are also beneficial when you are a saver. Your savings or investments will grow faster if the interest rates are high. This is why during periods of rising interest rates, savings products become more attractive.

Economic Control Tools

Central banks, such as the Federal Reserve of the United States or the State Bank of Vietnam, use interest rates as a primary tool to manage the economy. When they want to combat inflation, they raise interest rates to restrict spending. When the economy weakens, they lower interest rates to encourage borrowing and spending.

Protecting the Purchasing Power of Money

Inflation - the increase in prices of goods and services - always erodes the value of money. Interest rates help offset this by providing returns sufficient to maintain or increase your purchasing power.

What Factors Determine Interest Rates?

Interest rates are not random. They are determined by many factors:

Central Bank Policy

The central bank sets the base interest rate, and from there, commercial banks will establish their interest rates. The central bank's decision reflects how they want to adjust the money supply in the economy.

Inflation Rate

High inflation forces banks to raise interest rates to protect the value of money. Conversely, low inflation can lead to lower interest rates.

Credit Risk of Borrowers

Borrowers with poor credit histories will have to pay higher interest rates because lenders view them as higher risk. Conversely, those with good payment histories will receive preferential interest rates.

Conclusion

Understanding what interest rate is is the key to effective financial management. Whether you are a borrower, saver, or investor, interest rates directly affect your financial situation. Tracking interest rate trends, comparing rates from different institutions, and making informed decisions will help you achieve your financial goals wisely.