Understanding Different Types of Interest
1. Simple Interest
The most common type of interest, simple interest charges a fixed rate on the initial capital (principal) for a specific period. It’s typically calculated monthly but can also be annual. There are two ways interest rates are applied:
- Agreed Interest Rate: The rate is fixed at the start of the loan, regardless of market fluctuations.
- Current Interest Rate: The rate can change based on market conditions during the loan period.
Example: A $10,000 loan at a 2% monthly rate (24% annually) would result in $2,400 interest over a year. If the rate is variable, the monthly interest would be calculated based on the prevailing rate and added to the principal.
2. Compound Interest (Anatocism)
Compound interest, also known as anatocism, is prohibited by law. It involves adding earned interest to the principal, effectively charging interest on interest. This is only permitted when renegotiating an unpaid debt. For example, if a bank loan isn’t paid on time and is renegotiated, the accrued interest can be added to the principal for the new loan.
3. Interest in Advance
This type of interest is paid upfront when the credit is received, unlike other cases where interest is paid over the loan’s duration. It was common in the past when capital markets were less developed. Example: If a 90-day, $10,000 bill is discounted at 12%, the holder receives $8,800 upfront (after deducting $1,200 interest). This effectively results in a higher interest rate than 12% because the full $10,000 isn’t received. This practice was prevalent when capital markets were controlled and resources were channeled through specific credit lines.
4. Indexed Credit
Introduced with housing loans to encourage construction, indexed credit links loan repayments to an index like the Consumer Price Index (CPI) plus an interest rate. This protects lenders from inflation and encourages savings, which can then be used for financing housing purchases.
5. Interest in Foreign Currency
Similar to domestic currency loans, foreign currency loans typically use simple interest. There are two common methods:
- Foreign Currency Loan, Received in Pesos: The loan is in foreign currency, but the borrower receives the equivalent in pesos at the current exchange rate.
- Foreign Currency Loan for International Operations: The loan and repayments are both in the same foreign currency, often used for international trade or investment.
6. Weighted Average Interest
Used for medium and long-term fixed-rate loans, especially mortgages, this method addresses the issue of uneven interest payments over time. Example: A 20-year, $10 million loan at 10% interest with equal principal payments ($500,000 annually) would result in significantly higher interest payments in the early years. To smooth this out, the weighted average interest method calculates an average capital balance over the loan period (e.g., $5 million in this case) and applies the interest rate to that, resulting in a more consistent annual payment.
7. Net Present Value (NPV)
NPV is a financial metric used to evaluate the profitability of an investment by comparing the present value of future cash flows to the initial investment. Example: A $10,000 investment yielding $800 in year 1, $700 in year 2, and $800 in year 3 (total $2,300 or 23% return) might seem profitable. However, comparing this to an 8% return in the capital market (which would yield $2,400 over three years) reveals that the project might not be as attractive as it initially appears.