When taking out a loan or making a specific application in the investment portfolio , both debtors, creditors and savers want to know more about interest rates. And this is not for nothing, since it will define the cost of money in the time agreed between the one who lends and the borrower.

Therefore, all those who are considering taking out a loan, considering renewing a debt or wishing to make investments, whether in fixed income or in variable income, must understand the dynamics of **interest rates** . Thus, they will be able to make more strategic decisions in economic terms.

## What are interest?

Interest is the fee charged for borrowing money (or another item) between two or more parties. Normally, this financial term is expressed as a percentage to be charged on the borrowed amount or on the outstanding balance.

Thus, interest can be understood as a kind of “rent” value of capital in a given period of time. In other words, the percentage rate works as a compensation that must be paid by the borrower of the money for having the right to consume, invest or pay other debts with it.

The creditor, on the other hand, who lends his resources, receives financial compensation for being unable to use them during the loan to value ratio period and also for running the risk of not being paid for the loan granted. This being called credit risk .

With that, we have to:

- Debtor: the one who borrows the resource from the creditor and pays interest for it;
- Creditor: the one who has saved resources and who lends to debtors, in exchange for receiving interest.

## Credit Market: how does it work? What is it for?

It is possible to understand that the interest rate is the price of money in time, because when an individual grants credit to a borrowing agent , he is automatically postponing his consumption in the present in exchange for a greater amount of purchasing power in the future. future.

Therefore, this financial resource balances the propensity to save by some with the willingness to borrow money from others. In turn, the credit market is the one responsible for uniting those who wish to grant with those who need to borrow funds, with the country’s **basic interest rate** being an important benchmark in this process.

### What is the base interest rate?

Before understanding **what the basic interest rate** is, it is necessary to remember what a simple interest rate would be. In this sense, the indicator exclusively shows the percentage of the cost of a given capital over time.

It is also noteworthy that this cost can be seen from two perspectives: the creditor, who receives, and the debtor, who pays. Being that:

- Borrower’s perspective: the interest rate shows the cost that borrowed money will have over time and that will be paid to the lender;
- Lender’s perspective: the interest rate shows the cost that your debtor will have to pay to use the availability of the saver’s resource.

It should be noted that, obviously, interest rates on applications and loans vary greatly, depending on each operation. As a rule, the safer the operation, the lower the rate. And the more risky, the higher the interest.

But although there is no single rate for operations, there is an interest rate that serves as a reference in the entire economy of a country: the basic interest rate. Also known as the mother rate, it is the one set by the Central Bank of each country.

In Brazil, the basic interest rate is the Selic Rate, defined every 45 days by the Monetary Policy Committee (Copom) . The higher the Selic, the higher the rates practiced in the market. And the lower the indicator, the lower the interest charged by financial institutions and received by investors.

Obviously, there are several economic factors that influence the need to increase or reduce the Selic Rate and any basic interest rate in any country, such as inflation. However, to understand how interest rates work, it is enough to understand that their variation impacts all other rates in the economy.

## How does interest work?

After better understanding what he is, many people wonder **how interest works** . In practice, this should not be too complicated, since they can be represented in two ways, in percentage or in monetary value.

In the percentage case, the interest represents how much will be paid, in the case of a loan, on the outstanding balance. Or else how much will be earned in percentage, in case of a financial application, on the amount invested;

In the hypothesis of the demonstration in monetary value, the interest simply means how much money the debtor will pay for the loan of the resource. And in the case of an investment, it represents the amount of money received for having made a certain investment.

It should also be noted that in order to understand how interest rates work and what their applications are in the economy and in people’s lives, everyone needs to know the **difference between simple interest and compound interest** , as will be shown below.

### simple interest

Although some people confuse **simple interest** with compound interest, there is no reason to be confused, as the differences between them are easy. In the case of simple interest, the amount to be paid or received will be calculated based on the initial amount of the loan or application.

That is, regardless of the period in which the amount was applied or the duration of the loan, the interest received or paid will always be the same for all months or years. This is because, as stated, the basis for calculating simple interest is always the initial capital.

In the case of an investment, as the interest received is always the same, capital accumulation follows a first-degree function, with rectilinear growth. Below is an example of an investment of 10,000 reais yielding simple interest of 1% per month for 30 years:

### Compound interest

Unlike simple **interest, compound interest** is where interest is accrued on interest. That is, the monetary amount to be paid or received is calculated based on the immediately previous period, taking into account the updated and accumulated value of the application or the outstanding balance.

This is why compound interest is also called **interest on interest** . After all, at each new period the debit balance or the applied balance grows at a faster rate, exponentially.

To exemplify, consider the outstanding balance of a loan of 1,000 reais with compound interest of 1% per month:

- 1st month: 1000 + 1000*1% = 1010.00 (interest of 10.00);
- 2nd month: 1010 + 1010*1% = 1020.10 (10.10 interest);
- 3rd month: 1020.10 + 1020.10*1% = 1030.30 (10.20 interest).

Note that, unlike simple interest, whose interest is always fixed, calculated based on the initial amount; in compound interest, the amount is found by taking into account the balance of the immediately preceding period.

As a result, interest grows exponentially, vertiginously, according to a function of the second degree. That’s why investors often refer to its effects as “the magic of compound interest.”

Below, the same example of simple interest, of an initial investment of 10,000 with interest of 1% per month, but based on compound interest:

## How are interest rates calculated?

In order to know **how interest rates are calculated,** it is first necessary to understand the different types of interest that exist on the market. This is because each of these modalities will directly affect the calculation of the interest rate.

However, in general, to find the interest rate, just divide the interest for a given period by the principal amount. For example:

- Loan amount: BRL 1,000,000.00;
- Interest amount in the month: BRL 10,000.00;
- Interest calculation: 10,000 / 1,000,000 = 0.01 or 1% pm

In the same way that the debtor can calculate the percentage of interest he is paying, there is also the perspective of the creditor, who receives interest from a given application. In this case, the calculation could be:

- Amount applied: BRL 1,000.00;
- Amount received in interest in the month: R$5.00;
- Interest calculation: 5 / 1,000 = 0.005 or 0.5% pm

Despite the simple calculation, interest rates, most of the time, are not fixed in this way. This is because, depending on the type of interest, the percentage paid by the debtor or received by the creditor may vary according to economic indexes.

### Interest modalities

As mentioned above, interest cannot always be determined so far in advance. In other words, depending on the **type of interest** , its predictability will be compromised, which is why these types are also usually riskier.

To understand these types of interest, it is essential to understand well what would be the prefixed interest and post-fixed interest. Below, a little more about how each of them works.

#### prefixed interest

Pre – **fixed interest** , as the name implies, is pre-determined interest at the time the borrower takes out a loan. Likewise, from the investor’s perspective, the prefixed modality makes the investor know exactly how much interest he will receive on his investment.

Thus, regardless of any external economic variable, the interest paid by the debtor or received by the investor does not change. That is, it maintains the percentage that was initially agreed upon. For example:

- 10% per year;
- 1% per month;
- 5% per semester.

In the case of a prefixed investment, the agreed prefixed percentage is multiplied by the amount invested or by the outstanding balance to find the interest. With a rate of 1% per month, for example, the calculation would be:

- Outstanding balance of BRL 1,000,000.00 x 1% = BRL 10,000.00 of interest payable;
- Applied balance of BRL 500,000.00 x 1% = BRL 5,000.00 of interest receivable.

#### post-fixed interest

Unlike fixed rates, there is also a **post-fixed interest rate** . In this case, there are some differences for the person who will pay or receive the interest, the main one being the lack of predictability of what the final rate will be applied.

In the case of a post-fixed debt or investment , the final rate paid or received will depend on the variation of one of these economic indexes. Thus, if these rise, then the final rate will also appreciate. And, on the other hand, if they go down, the rate depreciates.

It should also be noted that post-fixed interest may or may not have a mixed modality, which is mixed, in part, with the fixed rate. For example:

- IPCA + 0.7% per month;
- IGPM + 5% per year.

On the other hand, there is also the possibility that post-fixed interest does not have a mixed rate with a fixed part. In this case, it could be an application or a debt contracted at a rate of 120% of the CDI.