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Definition of Interest Rate:

“The price which a borrower pays for the use of money that he or she does not own, and has return to the lender who receives for deferring his consumption, by lending to the borrower”.

Definition of Annual Percentage Rate (APR):

“The percentage cost of borrowing per year, including interest fees”.

For example:

A $1000 loan repaid in its entirely after one year with $80 interest plus a $10 service fee, has a total finance charge of $90, and so has an APR of 9%.

If pure interest is calculated over the same period of time in the same money market, it will tend to be the same. It can, however, differ in different markets on account of the following differences.

Difference in the Period of Loan:

Firstly, if a borrower takes a long term loan from the lender, then he will charge a higher rate of interest than what he charges for the short period loan. It is because the lender has to part with his money for a longer period, so he must demand a higher rate of interest.

Secondly, in a long term loan, the risk of the loss of funds due to dishonesty or incapability of the borrower are more than on a short term loan.

Thirdly, businessmen demand money for a fairly long period in order to invest that fund in fixed equipments, like building machinery, etc., so they are ready to pay higher rate of interest.

Fourthly, the lender hesitates to lock up their money for longer period keeping in view the various risks involved. Due to all these factors stated above, the supply of loan able funds runs short of demand for loan able funds and the rate of interest goes up. On the other, hand, for a short period, the risk for the loss of capital is less than on the long period. The supply is generally in excess of demand for this fund. So the rate of interest is usually low.

Short term and long term rates of interest generally move in the very same direction. If the short term rate of interest is high, the long term rate of interest is also high. If the short term rate of interest is low, the long term rate of interest is also generally low.

Differences Due to Distance:

Pure interest can differ due to difference in the distances of the money market. It is the desire of every money lender to reduce the risks of non-payment of money. So they will prefer to invest their amounts near at home at a lower rate of interest than at a higher rate of interest at a long distance.

Difference in Size of Loan:

Pure interest or net interest can also differ due to the differences in the amount of loan demanded. The higher the amount demanded for loan, the higher the rate of interest and vice versa.