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
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?