What are interest rates and how do they work?

What are the types of interest rates?

There are different types of interest rates, identified by who issues them. They are:

• Central bank interest rates – national interest rates adopted by a country and determined by that country’s central banking authority. In the case of the Singapore, that’s MAS
• Bank account interest rates – interest rates set by local or regional banks, which are affected by the central bank’s rates
• Mortgage interest rates – rates on loans, such as home loans for those buying a new house, given out by lenders like banks

How do interest rates work?

Interest rates come part and parcel with the loan you’ve taken out, or as part of the savings you’ve amassed. In the case of a loan, your total loan repayments plus the calculated interest amount would be divided into a monthly sum for you to pay (as a minimum amount – you can always pay more).

In the case of savings or investments, the interest rate would be the amount that your savings appreciate by each year. Either way, the interest is indivisible from the total amount – and the interest rate is how much that amount grows by.

Example of interest charged on borrowing

The same is true for a loan. Let’s say you approach your bank for a home loan of $100,000. If the bank grants you that loan, they’ll charge a certain amount of interest on top of the loan. Among the various types of loans you may acquire, this may be worked out as a fixed amount, a variable amount that depends on economic conditions or a percentage that’s payable annually.

Let’s say you get a fixed loan of $100,000 with a fixed interest rate of 4%, with monthly payments calculated on the length of your loan. If you were to take out the loan for a 50-month period, you wouldn’t only have to pay $2,000 each month ($100,000 divided by 50 months) but an additional 4% of that monthly amount ($80) is payable due to interest. So, you would have $104,000 ($2,080 x 50 months) to repay for the $100,000 loan.

What is APR and how does it differ from interest rates?

Annual percentage rate (APR) is a charge by lenders that’s different to your interest rate.

A lender, like a bank, will often also charge small additional amounts for services rendered over and above the interest. Examples of this would be a fee for opening the mortgage at the start or closing it when the loan term is up, or broker fees.

For this reason, lenders advertise an APR rate, which gives you the total cost of both the interest and any of these additional payments in one amount. It’s often a more accurate way of depicting the true cost of your loan, without any hidden fees.

What is compound interest and how does it work?

Compound interest is a wealth generation phenomenon, where your interest on savings begin to earn interest. This ‘interest on top of interest’ means that your money continues to grow itself.

Let’s look at our previous example to illustrate this. If you have $1,000 in a savings facility where the interest means it grows by 5% per annum, that would be $50 for the first year. However, this doesn’t mean your savings grow by a static $50 each year – instead, in your second year, your amount will grow by 5% of $1,050, which is $52.50. In the third year, you’d earn 5% interest on $1,102.50. By the end of the tenth year, your $1,000 would’ve grown by more than 50%, to over $1,600.

As you can imagine, this has a snowball effect and gets exponentially bigger over longer periods of time.

Compound interest works the other way, too. If you were to take out a loan of $2,000 with an interest rate that compounded 20% annually, after just three years, the total payable amount would be $3,456 – almost double your loan amount – as 20% of the total keeps growing in size with each year.

How are interest rates decided?

Interest rates for traders and investors

On a surface level, a higher interest rate will mean more profit for investors, as the rate at which their investments grow is accelerated.

For traders, however, this goes deeper, as the very conditions around changing interest rates are waves and swells in the market that can be traded for profit – or at a loss. A sudden change in interest rate stance can lead to volatility in the marketplace, which can be an opportunity to trade.

For this reason, many traders and investors watch interest rates and the discussions around them with great interest and attention.

You can trade on interest rates directly by predicting at key times on whether interest rates will go up or down. This can be done with derivative products like contracts for difference (CFDs), and can be done on our platform.

However, taking a position on interest rates is a complex and risky form of trading that comes with inherent potential loss. Also, CFDs are leveraged financial products. You would put down an initial deposit to open a larger position, with both profits and losses being calculated on the total position size. This means that leveraged products carry inherent risk of your losses or profits substantially outweighing your initial deposit.²