Money Interest Rate Formula

Money Interest Rate Formula

Money Interest Rate formula has been given below. Money Interest rate formula has been explained with an example

(1+m) = (1+i)(1+r)

By Re arranging the formula

(m) = (1+i)(1+r)-1

Where;

m=money rate

i= inflation rate

r= real rate

Money Interest Rate Formula Example

Inflation Rate = 5%

Real Rate required by Investor = 4 %

Calculate Money Rate=?

Solution

(1+m) = (1+i)(1+r)

Money rate = (1.5%)(1.4%)-1

= (1.092)-1

=9.2%

Money Rate Quick Calculation

Money interest rate can be quickly calculated by adding the real interest rate and inflation rate. However, for more accurate calculation the fished effect formula (as shown above) is used. In above example, the quick calculation gives an answer of 9% (4%+ 5%), while fisher effect formula given an answer of 9.2%.

Significance of Money Rate

In real life money rate concept is used, because money rate is offered after considering the inflation in the economy. All financial instruments are offered at money rate of interest.

Characteristics of Money Rate

1.    Money Rate is inclusive of inflation rate

2.    Money rate is used in financial market for offering different products.

3.    Money Rate is simple to understand and apply

4.    money interest rate or nominal interest rate is an effective tool for controlling inflation

Other name of Money Rate of interest

Other name of money rate of interest is nominal rate of interest. These both terms can be used interchangeably.

Money Interest Rate and Inflation

In case of high inflation rate, the interest rates are kept high by the central bank to reduce the money supply for controlling inflation in the economy. Therefore money interest rate is an effective inflation controlling tool.

Money Interest Rate and recession

Money interest rate can also be used to end the recession (boosting economic activity). Interest rate can be lowered to boost the economy activity in the economy. At lower bank interest rate people would take the loan and invest them in market.

Real Interest Rate Formula

Real Interest Rate Formula

Real interest rate formula has been shown below. Real interest rate formula has been explained with an example

(1+m) = (1+i)(1+r)

Real interest does not incorporate inflation (interest rate exclusive of inflation). The above formula is known as fisher effect.

Re arrange formula

r         = (1+m)   -1

              (1+i)

m=money Interest rate

i= inflation rate in the economy

r= real Interest rate

Real Interest Formula Example

Prevailing Inflation rate in country = 10%

Money Rate in market or country = 14%

Calculate real rate

Solution

r        = (1+m)   -1

              (1+i)

r       = (1+14%) -1

              (1+10%)

=3.63% (Real Rate)

Quick Calculation of Real Interest Rate

Real interest can be roughly calculated by subtracting inflation rate from the money rate. However it is important to remember that such calculated rate would be slight different from the actual real interest rate (which is calculated by above formula).

 Significance of Real interest Rate

Real interest rate is wide used in investment appraisal, because investors are more interest in real return than money return. It is important to note that risk may be analyzed more effectively with the help of real interest rate.

Limitation of real interest Rate

Real interest cannot be calculated exactly, because future inflation rate cannot be estimated exactly.

Characteristics of Real Interest Rate

1.    Real interest rate does not include inflation

2.    Real interest project real return for the investors.

3.    Real interest rate offered is based on assumed inflation rate in future.

Simple Interest Formula

Simple Interest Formula

Simple Interest Formula has been given below. Simple Interest concept has been explained with an example. Simple interest formula can be used in two ways i.e. calculating the amount of interest and calculate the future value of investment.

Simple Interest = P (Rn)

Future Value = P ( 1+ Rn)

Future value is calculated by the following simple formula

R= rate of interest

N = number of period

P = Present value

Simple Interest Formula Example

Bank Offer Simple Interest Rate= 14%

Deposited Amount by Mr. A= 400,000

Calculate Simple interest & Future Value for 2 years?

Solution

In first place we calculate the future value and then we would calculate the interest value. It important to note that interest can either be calculated from the future value or can be directly calculated by a formula.

Future Value Calculation

= $ 400,000 (1+ .14x2)

=$ 400,000 x 1.28

=512,000

Interest Value Calculation

Interest can be calculated in two ways either by calculating future value and then deducting present value from future value or by directly using interest.

Method 1

Interest for 2 Years i.e. (Future Value – Present Value)

512,000 – 400,000 = 112,000

Method 2

Simple Interest = P (Rn)

= 400,000 x (.14x2)

= 400,000 x .28

=112,000

Characteristics of Simple Interest

1.    Interest Rate remains same for each year

2.    Simple interest is calculated only on the principal amount

3.    No interest is calculated or paid on interest earned.

4.    Simple Interest can be paid periodically and on maturity

 Simple Interest Vs Compound Interest

Simple interest remains same for all period, where compound interest changes each year (increased with each passing year). Simple interest in only calculate on the bases of principal amount, where compound interest takes into account both principal and interest already earned on principal amount.

Period or number of period has great significance in the compound interest, where in case of simple interest number of period has no significance. Simple interest concept can be used both for annual or periodical payment, where compound interest concept is only valid for maturity payment.

Compound Interest Formula

Compound Interest Formula

Future value Formula = P (1+r) n

P= Present Value

r= rate of interest

n= number of period

Compound Interest Formula Example

Bank Deposit= 200,000

Bank Rate of interest = 12%

Calculate future Value after three Years using Compound Interest?

Future value = P (1+r)ⁿ

= $ 200,000(1.12)³

= $200,000 x 1.4049

=$ 280,985

Interest for three years = future value – present value

= 280,956.8- 200,000

=80,985

Compound Interest Formula Calculation

Compound interest formula takes into account the capital amount and interest earned on the capital amount for interest calculation.

Use of Compound Interest formula

Compound interest is widely used for future value of the bonds. Compound interest formula is applied, where interest is paid on the maturity. Compound interest formula is not valid for regular interest payments.

Characteristics of Compound interest Formula

1.    Interest is paid at the maturity date

2.    Interest for each year is more than last year

3.    Offer higher return than simple interest

 Simple Interest & Compound Interest

Compound interest and simple interest are two different method of offering interest.  In simple interest a fixed amount of interest is offered each year (which may be paid periodically or on maturity).

In case of compound interest, the amount of interest is increasing each year and compound interest is paid on maturity along with capital amount.

 Compounding Vs Discounting

Compounding and discounting are two opposite concept. Compounding is calculation of future value based on a interest rate (Discounting Factor), While discounting is on other hand is a present value of future cash flows are amount. This concept has been explained with an example

Bank Deposit by a Person = 300,000

Bank Rate of interest or Discount Factor = 13%

Calculate future Value (Compounded Value & Discounted Value)?

Solutions

In first place we would calculate compounded value and then discounted value

Compounded Value

Future value = P (1+r)ⁿ

= $ 300,000(1.13)³

= $300,000 x 1.4428

=$ 432869

Discounted Value

Discounted Value = P (1+r)^-n

= 432869 x (1.13)^-3

=432869 x .6930

=300,000