What are interest rates and why are they charged?

This is an indicator that is expressed as a percentage and is used to estimate the cost of a loan or the return on savings or investment. Interest rates establish a balance between the risk and the possible profit of using a sum of money in a given situation and time.

The interest rate can be fixed (it remains stable for the duration of the investment or the loan is repaid) or variable (it is updated, generally, monthly, to adapt to inflation, the variation of the exchange rate, and other variables).

What are the different types of interest rates?

Interest Rate Types

There are two types of interest rates:

  • Nominal: as explained in the section “What is interest?” There are simple and compound interests. The nominal rate is the return or interest of a financial product month by month or in a given period, taking into account only the initial capital; that is, calculate simple interest.
  • Effective: the effective rate for its part takes into account the reinvestment of interest or income generated; in other words, calculate compound interest. Colombian financial entities use compound interest for their operations, so this rate represents what you will ultimately pay if you ask for a loan or what you will be paid if you save or invest.

When comparing different financial products, keep in mind that a nominal rate can be converted into an effective one and vice versa, so it may be the case that some entities tell you that the rate of a loan is 2.08 nominal monthly and others that it is 28% annual effective; rates that are exactly the same. To learn more, Ser Más recommends that you always check the Annual Cash rates, so it will be easier to compare who pays you better returns or lower interest.

What do the types of interest rates depend on? – Interest classes and their risks

Many variables influence the interest rate that you as a client pay to a financial institution (or vice versa), below we will explore the most important ones:

The decisions of the Banco de la RepúblicaThe media constantly refer to the decision of the Banco de la República to increase, decrease or keep the interest rate stable; however, what does this mean and how does it influence your life?

The monetary policy intervention rate of the Banco de la República (sometimes called only “interest rate”), is the minimum rate charged by the central bank to financial entities (such as banks) for the loans it makes to them, as well as as the maximum interest rate you will pay them for receiving money left over. These rates are the main monetary policy intervention mechanism used by Banco de la República to affect the amount of money circulating in the economy.

Low-interest rates help the economy grow since they facilitate loans and increase consumption and therefore the demand for products. The more products consumed, the more economic growth. The negative side is that this consumption has inflationary tendencies. On the other hand, high-interest rates favor savings and curb inflation, since consumption decreases as the cost of debt increases. But as consumption decreases, economic growth is also slowed down.

The risk

By transferring ownership of money, there is a risk of losing it, which is why financial institutions have different interest rates depending on the destination given to the money: the more risk, the more expensive the credit will be.

For example, the interest rate of a loan through a credit card will be higher than in the case of credit for the purchase of a vehicle. In the first case, the client uses the limit on his card and the entity does not have many ways to enforce payments, while in the second case, if the client does not pay the financial institution, he has the vehicle as collateral, and that means less risk.

To mitigate credit risk, financial institutions have strict requirements and policies when lending money, among which are a detailed analysis of your ability to pay based on income and indebtedness, reviews of your credit history, since it is analyzed that the income is real and that the monthly expenses are by their economic reality.

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