The definition of interest is simple, but the actual implementation from a bank is complicated. From a borrower's perspective, interest is calculated upon the amount of money that is borrowed. When a borrower is repaying on a home loan, the borrower incurs an interest expense. While the borrower is required to pay the interest expense, the lending institution earns interest revenue. One can not have interest expense without having interest revenue. These two concepts go hand-in-hand. There is a simple formula for calculating interest.

How Interest is calculated

Before we discuss the formula for calculating interest, it is important to know three definitions. The first definition deals with Principal. Principal is the borrowed amount of the home loan. An interest rate is the percentage that is either paid or earned per year. The duration of the loan is the number of years that the borrower has to pay on the home loan. Interest is calculated by taking into consideration the principal amount, the interest rate, and the duration of the loan. The formula looks like this: Total Interest = Principal * Interest Rate * Duration.

The Definition of Annuity

An annuity is a series of payments that are of an equal amount, separated by equal intervals of time. When someone requires a service or goods and in exchange agrees to make a series of payments to the particular supplier, then he or she has entered into a transaction known as an annuity. A mortgage can be considered to be an annuity.

For example, a thirty year home mortgage or a five year car loan, are types of annuity transactions. In these cases, an increase in interest rates will cause the amount of each payment to increase. This is a standard practice for a fixed interest rate home loan and a variable interest rate home loan. However, with a variable interest rate home loan, the amount of your payment can increase much more drastically, depending on the conditions of the market.

Different Lending Interest Rates

The most popular lending interest rates are prime rates, consumer rates, and discount rates for both mortgages and auto loans. A discount rate is the set rate determined by the Federal Reserve Bank. This is the rate that the Federal Reserve Bank charges financial institutions and banks to borrow funds directly from the central bank. The discount rate directly affects the rate that customers are charged.

A prime interest rate is the rate that is charged by large commercial institutions and banks to credit worthy customers. Most major banks have very similar prime interest rates. The prime interest rate is the most commonly used benchmark, when setting credit card rates and home equity lines of credit.

A consumer interest rate is a representation of the rates that banks lend funds to ordinary individuals. A consumer interest rate is used to determine auto loan rates, mortgage rates, and credit card rates. Some consumer loans, such as a mortgage line of credit, are priced at the prime interest rate.