Interest Rate and Rate of Return
Interest is the manifestation of the time value of money. Computationally, interest is the difference between an ending amount of money and the beginning amount. If the difference is zero or negative, there is no interest. There are always two perspectives to an amount of interest—interest paid and interest earned.
These are illustrated in Figure 1–2 . Interest is paid when a person or organization borrowed money (obtained a loan) and repays a larger amount over time. Interest is earned when a person or organization saved, invested, or lent money and obtains a return of a larger amount over time. The numerical values and formulas used are the same for both perspectives, but the interpretations are different.
Interest paid on borrowed funds (a loan) is determined using the original amount, also called the principal,
Interest = amount owed now - principal
When interest paid over a speciļ¬ c time unit is expressed as a percentage of the principal, the result is called the interest rate.
The time unit of the rate is called the interest period. By far the most common interest period used to state an interest rate is 1 year. Shorter time periods can be used, such as 1% per month.
Thus, the interest period of the interest rate should always be included. If only the rate is stated, for example, 8.5%, a 1-year interest period is assumed.
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Figure 1–2
(a) Interest paid over time to lender. (b) Interest earned over time by investor. |
EXAMPLE 1.3 Interest Rate and Rate of Return
EXAMPLE 1.4 Rate of Return and Rate of Return
EXAMPLE 1.5 Interest Rate and Rate of Return
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THE FUNDAMENTALS
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