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Interest rates in common parlance refers to the cost of capital i.e. some portion of principal amount which is charged by the lender from the borrower. Some of the key components of interest rates are given below:-
For an accountant, it is very essential to understand all the components of interest rates due to the following reasons:-
The time value of money is the principle that 1 dollar today is worth more then 1 dollar tomorrow. It is also the fundamental and guiding principle behind almost every financial and investing decision. It helps you evaluate and assess future risks and decisions. Basically, TVM is not just letting money sit in your pocket and burn a hole, it can be put to work – that may be investing in real estate, certificates of deposit or stocks as examples of how to make each dollar worth more in the future.
Several important terms and pieces factor into determining the time value of money in the future. There is present value, there is interest or return, there is the number of years invested and there is the number of years of compounding interest (Lusk, 2021).
There are several components of interest. Two common types of gained interest are simple and compounding interest, one that accumulates with the interest earned each year, and simple which is the interest from the principle paid each year. A third one is termed as accrued.
Accountants must have a good understanding when balancing, and budgeting for the future. One simple mistake can make or break the financial decision making process – it can be the difference between being under, at or above budget.
Lusk, Veneta. (2021). Time value of money: The guiding principle for virtually every financial and investing decision. Business Insider. https://www.businessinsider.com/time-value-of-money
The time value of money is a concept that helps us to understand how the value of our money changes over time. This change can go in either direction, up or down, and is affected by things like inflation, interest rates, and the total time span in consideration. Time value concepts can help us determine the value of an investment made today of a specific amount at a specified interest rate, for a future point in time. The same holds true for the reverse, if we need to know how much to invest today in order to have a specific amount in the future, time value helps us get there.
When thinking about interest rates it is important to understand that at the most basic level interest is the cost of borrowing money for the borrower and the potential income from lending the money to the lender. There are 3 components within interest rates. The first is the real interest rate, which is the return the lender wants for lending their funds. The second component is inflation, due to the fact that over time the purchasing power of a dollar tends to decrease. Therefore this must be factored into interest rates so that lenders receive an adequate return. The third component of interest rates is risk or risk premium. This takes into consideration the possibility that the lender may not get repaid the funds they have loaned. Therefore the risk premium associated with interest rates will vary from case to case, depending on things like creditworthiness, income, and collateral.
It is important for accountants to understand the components of interest rates because each of these factors plays a role in understanding financial statements and making decisions regarding finances. For example, if inflation has just seen a sharp rise, and your client has a significant amount of debt relative to equity on the books, you may not recommend financing a new purchase, as the interest rate charged will be much higher, than if they could wait until they have paid down some of the debt, and/or inflation has decreased, paving the way for a lower interest rate.
“Time Value Of Money”. CFI, 2022, https://corporatefinanceinstitute.com/resources/knowledge/valuation/time-value-of-money/ (Links to an external site.).
Hofstrand, Don. “Understanding The Components Of An Interest Rate”. Iowa State University Extension And Outreach, 2022, https://www.extension.iastate.edu/agdm/wholefarm/html/c5-94.html (Links to an external site.).