Different Types Of Interest Rate – Terminologies  

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  • Interest rates, Personal Finance
  • 5 min read
  • Jiraaf
  • Mar 28, 2023

Yield, return, interest, coupon, and more – if you’re someone who has read all this jargon and gotten confused, the next 5 minutes will give you a crystal-clear picture of what these terms mean.  

We all know that interest in finance means the cost of borrowing or the compensation for lending money. But it is generally the terminologies related to interest that often create confusion. Terms like yield, return, coupon, and likewise are wrongly used interchangeably which may cause grave financial mistakes. This article is all about demystifying the jargon in a simplified way. 

Let us begin to know the types of interest rate. 

Types of Interest Rates 

Simple Interest and Compound Interest 

Let’s get back to school mathematics!

Simple Interest is where, if you invest money, you earn a fixed interest on it every year. For example, if you invest Rs. 100 at a 10% simple interest, you’ll earn Rs. 10 at the end of the year as interest, and your principal (Rs. 100) will be paid back to you after the said duration. 

Compound Interest is different. Here, you get interest on the principal + interest on interest. 

Confused? Don’t worry, let’s take the same example for compound interest. 

Now, if you invest Rs. 100 at 10% compound interest, in the first year, you earn Rs. 10 as interest on Rs. 100. But in the second year, your principal is now Rs. (100+10) = Rs. 110. So in the second year, you’ll make 10% of Rs. 110 = Rs. 11. The third year will make your principal as (110+11) = Rs. 121, and your interest will be Rs. 12.10 

Do you see how your money gets multiplied every year? That’s compound interest! 

That’s the reason Einstein, says that “compounding is the eighth wonder of the world”. It truly compounds your wealth! 

Coupon 

If you’ve ever invested (or considered investing) in bonds, you would have come across “coupon”. The coupon for a bond is nothing but the interest that the bond issuer pays an investor on the face value of the bond. 

Wait, what’s “face value” now?

Well, face value is the price of the bond set by the issuer. So, for a bond of face value 100 and coupon 7% p.a, you, as an investor will get Rs. 7 every year as interest. 

But this coupon is calculated on “face value”. The actual market price of the bond could be different, depending on demand-supply and market volatility. So essentially, the “ROI” that you make on a bond will be different from the coupon. Let’s see what that is! 

Yield 

Just like stocks, bonds have a face value (determined by the bond issuer) and a market value (which is determined by demand and supply). 

Now, let’s take the above example of a 100-rupees bond with a 7% coupon. Now say that the demand for this bond is high, and people are willing to pay Rs. 105 for the same bond. You, therefore, buy it for Rs. 105.  

But here’s the thing – the coupon for a bond is fixed and does not change. So Rs. 7 is the interest you receive but on your investment of Rs. 105.  

This makes your effective ROI not 7% but (7/105) = 6.67%. That is your bond’s yield. 

Discount Rate 

The interest rate used to determine the present value of future cash flows is called a discount rate. This can be understood better with a simple example. 

Imagine a scenario where you invest Rs 1000 in two different investments – Option A & Option B, both are let us say debt instruments.  

Option A repays Rs 200 every year for 10 years, while Option B repays Rs 300 every year for 5 years. You want to discount both these investments at 10% assuming that is the needed annual return you typically want in your investments.

Which one would you prefer?  

Option A – Cumulative repayment of Rs. 2000 over 10 years for Rs. 1000 investment today 

Option B – Cumulative repayment of Rs. 1750 over 5 years for Rs. 1000 investment today 

If your answer is Option A, you are not completely wrong in thinking that way as you get Rs. 250 more cash compared to Option B. 

But let us look at the underlying numbers: 

Option A – Net Present Value (NPV) of future cash flows is Rs. 228.91  

Option B – Net Present Value (NPV) of future cash flows is Rs. 326.78 

This is because cash in hand early has more value and is always preferable as it provides the chance to reinvest and earn from it. 

In this example, Option B wins over Option A. 

In the world of finance, this is known “time value of money”. The value of an amount today is higher than the future value of the same amount. And to calculate the present value of a future sum of money, we use the “discount rate”.  

Here’s how it’s calculated: 

PV = FV/[(1 + i)^n] 

[PV = Present Value; FV = Future Value; i = discount rate; n = Number of years] 

For example, if you want to know what Rs. 1,000 5 years later will be valued today discounted at a rate of 10%, you will use the below formula: 

PV = 1000/(1+0.1)*5 = 620 

Therefore, Rs. 1000 5 years later, discounted at 10%, is worth only Rs. 620 today. 

Yield to Maturity 

The present value of all payments of the bond, i.e the present value of its interest and principal is the yield to maturity. 

You see bonds typically pay interest over their maturity period (3 months, 5 years, 10 years – could be anything). So, if you want to calculate ROI of the bond you hold till its maturity period, then this ROI is calculated using a formula, known as Yield to Maturity (or YTM). 

Internal Rate of Return (IRR) and Extended Internal Rate of Return (XIRR) 

Let’s take an example of a SIP. When you do, say, a monthly SIP, how will you calculate the returns? 

You have a regular stream of investments that you’re making, and one final amount you get as the corpus. In such a case, we use a metric known as IRR (or internal rate of return) to calculate your returns. Technically, IRR is the annual rate of return that you get on your investment when there are multiple inflows or outflows. 

An extension to IRR is the XIRR. While IRR is the high returns when the inflows/outflows are spread across regular intervals, XIRR is the return when the inflows and outflows are not regular. So, if you, for example, have a monthly SIP, you can use IRR. But if you have irregular lumpsum investments and want to know your return, you’ll use XIRR. 

IRR and XIRR can be calculated in Ms-Excel using its built-in formulae. 

Conclusion 

Now that you know what the different kinds of interest rates are, we hope you’ll be able to make better decisions with your money! There are a bunch of calculators available on various websites to calculate all the above rates. You just need to input certain values, submit and the website will give you the return. Interest rates are assumed to be per annum if no information about tenure is mentioned.  

This article is not an all-inclusive list of various interest rate terminologies used in India. But sufficient for a beginner to breakdown down most investments available in the market. 

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