Interest Rate
Interest rates are used to calculate the amount charged by a lender to a borrower for the use of funds, or the amount earned by an investor on their investment. Usually expressed as an annual percentage rate (APR) in lending, the interest rate is the percentage of the principal that the borrower pays for a specific time period (e.g. yearly, quarterly, or monthly). For example, on a loan with a 5% interest rate, the borrower will pay 5% of the principal balance in interest each year.
Interest rates are either fixed or variable:
Fixed interest rate: The interest rate remains constant throughout the life of the loan or investment. This provides predictability in monthly payments and total interest costs.
Variable (or floating) interest rate: The interest rate can fluctuate based on market conditions, usually tied to a benchmark rate such as the prime rate. Payments can vary over time, which can affect budgeting and cash flow.
Simple vs. Compound Interest
Interest rates can be difficult to understand and compare due to variables including associated fees and different methods of calculating interest. It’s important to understand if a quoted interest rate on a business loan takes into account compounding or not, because this can significantly change the cost of borrowing.
Simple interest does not factor in compounding. It is calculated only on the principal amount for the entire duration of the loan or investment. The formula is:
Interest = Principal × Interest Rate × Time
For example, if you get a $100,000 business loan with a 5% annual interest rate and a 3-year term, the simple interest you’ll pay is: $100,000 × 0.05 × 3 = $15,000.
Compound interest is calculated on the principal as well as on the accumulated interest from previous periods. This means that interest is earned on interest. The formula for compound interest is:
A = P (1 + (r ÷ n))^nt
Where:
A = the future value of the investment/loan, including interest
P = principal investment amount (initial deposit or loan amount)
r = annual interest rate (decimal)
n = number of times that interest is compounded per year
t = number of years the money is invested or borrowed
Using the example from above, the interest you’ll pay on a similar loan that’s compounded annually is:
A = $100,000 (1 + 0.05) 1 × 3 = $100,000 (1.05)3 = $115,762.50
As you can see, there’s a big difference in your borrowing costs on a $100,000 3-year term loan with yearly compounding — you’ll pay $100,762 more in interest.
Financial Glossary
Use Lighter Capital's glossary to understand common terms used in finance and investing, so you can build financial literacy and make informed decisions for your startup.
Interest Rate
Interest rates are used to calculate the amount charged by a lender to a borrower for the use of funds, or the amount earned by an investor on their investment. Usually expressed as an annual percentage rate (APR) in lending, the interest rate is the percentage of the principal that the borrower pays for a specific time period (e.g. yearly, quarterly, or monthly). For example, on a loan with a 5% interest rate, the borrower will pay 5% of the principal balance in interest each year.
Interest rates are either fixed or variable:
Fixed interest rate: The interest rate remains constant throughout the life of the loan or investment. This provides predictability in monthly payments and total interest costs.
Variable (or floating) interest rate: The interest rate can fluctuate based on market conditions, usually tied to a benchmark rate such as the prime rate. Payments can vary over time, which can affect budgeting and cash flow.
Simple vs. Compound Interest
Interest rates can be difficult to understand and compare due to variables including associated fees and different methods of calculating interest. It’s important to understand if a quoted interest rate on a business loan takes into account compounding or not, because this can significantly change the cost of borrowing.
Simple interest does not factor in compounding. It is calculated only on the principal amount for the entire duration of the loan or investment. The formula is:
Interest = Principal × Interest Rate × Time
For example, if you get a $100,000 business loan with a 5% annual interest rate and a 3-year term, the simple interest you’ll pay is: $100,000 × 0.05 × 3 = $15,000.
Compound interest is calculated on the principal as well as on the accumulated interest from previous periods. This means that interest is earned on interest. The formula for compound interest is:
A = P (1 + (r ÷ n))^nt
Where:
A = the future value of the investment/loan, including interest
P = principal investment amount (initial deposit or loan amount)
r = annual interest rate (decimal)
n = number of times that interest is compounded per year
t = number of years the money is invested or borrowed
Using the example from above, the interest you’ll pay on a similar loan that’s compounded annually is:
A = $100,000 (1 + 0.05) 1 × 3 = $100,000 (1.05)3 = $115,762.50
As you can see, there’s a big difference in your borrowing costs on a $100,000 3-year term loan with yearly compounding — you’ll pay $100,762 more in interest.
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