Question

Question:What are the components of an interest rate? Why is it important for accountants to understand these components?

Short answer

The components of interest rate are pure rate on interest, the expected inflation rate of interest, and credit risk rate of interest. Accountants should have knowledge of these because it will help in choosing the best interest rate for a company.

Step-by-step solution

Step-by-Step solutionStep 1 Components of interest rate

The three components of interest rate are as follows:

Pure rate of interest: It is the amount charged by the lender in the case when there are no possibilities of default and expectation of inflation.

The expected inflation rate of interest: In the inflationary period lenders recognize that they are paid less in form of interest. So, to cover the loss they charge higher interest in a high inflation period.

Credit risk rate of interest: The business organizations can have low or a high credit risk depending upon their financial ability and profitability.

Importance to understand the components by the accountants

To identify the best appropriate interest rate for a given company, accountants of the company must have knowledge about the abovementioned components of the interest rate