The word rate is used in many different situations. It is short for representing the rate of change over time. It is frequently used in the financial world to describe the actual rate of change (or growth) of a portfolio or how it is predicted to grow in a future period. It is most frequently used however to describe a rate of interest in either an interest earning account or the rate of interest paid on a loan or mortgage.
An interest rate is described as a percentage using the symbol ‘%”. The percentage symbol simply means that the number should be dived by 100 to reach the actual value. Unless otherwise specified, it’s assumed that the interest rate is calculated over the period of one year. If one was paying an interest rate of 3.5% on $100,000 one could calculate the annual interest simply by calculating (3.5/100) x $100,000 = $350.
Rates can be fixed or variable. An investment that pays a fixed rate of interest guarantees you that you’ll get your principal back plus an amount equal to the fixed rate of interest. Unless otherwise indicated the interest will compound annually. Using the numbers in the previous example you would earn $350 in the first year and if you maintained that investment for another year you would begin to earn interest on your interest. Mathematically it would look like this (3.5/100) x $100,350 = 3,512.25.
Alternatively, the rate of interest could be variable. Due to the inherent uncertainty, a variable interest rate represents more risk to the recipient. This additional risk typically means that a borrower has an opportunity to pay less interest and an investor has the opportunity to earn more interest. A variable interest rate tends to be a better option for a more financially sophisticated individual who is comfortable with some level of risk. Variable rates of interest will compound annually as well, unless specified otherwise.