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Level 2 Business and Economics: External Influences

Changes in Interest Rates

An interest rate is the price of acquiring a loan. Businesses of all sizes borrow money, often from banks, to help finance their activities. Banks are effectively using someone else's money to lend to you, the business. As a result, the bank imposes a charge for the privilege - this charge is the interest.

The interest rate is usually expressed as a percentage. If a firm borrowed £100,000 over a five year period (that means they have five years to pay back the £100,000) at an interest rate of 10%, then the firm will have to pay back £ 10,000 a year in interest to the bank.

There are some terms to remember when looking at loans.

  • Principal (p) - this is the amount of the loan - the amount of money borrowed.
  • Rate of Interest (r) - the rate of interest that the borrower has to pay, expressed as a percentage.
  • Time (t) - the time period of the loan: some loans might be taken out over a few days or months, others over many years.
  • Interest (I) - the total amount of interest to be paid on the loan.

The formula for calculating simple interest is:

I = p x r x t

So, if I wanted to borrow £5,000 from a bank over a period of 2 years, at an interest rate of 5%, the total interest I would have to pay would be:

  • I = 5,000 x 5% x 2. (5% = 5/100, which equals 0.05)
  • I = 5,000 x 0.05 x 2
  • I = £500.

The monthly interest payment, therefore, would be £500 / 24 = £20.84. The total paid back to the bank would be £5,500.

Task

Filling out a loan application

Whatever the size of the business and whatever it sells, it is likely that it will have to raise funds through a loan. Changing interest rates can affect the amount that the business has to pay back not only each month but in total! Copyright: Jan Stastny, from stock.xchng.

A small pet foods business has bought premises in a parade of shops in a small town. The owner, Jenny, has decided that she wants to invest in improving the quality of the interior of the shop. She has had a quote from a firm of decorators and has also looked into buying new fixtures and fittings for the store. This includes a new counter, shelves, display stands, till and payment system for accepting credit cards.

Jenny has decided to raise a loan from her bank and has negotiated a three-year loan of £25,000 at an interest rate of 12.5%.

  • Assuming simple interest, calculate the monthly interest that Jenny will have to pay
  • Calculate the total payments per month that Jenny will have to make, including interest, to repay the loan
  • What is the total amount of money that Jenny will have to pay over the three years of the loan agreement?

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