When a business borrows funds to raise capital, the company must pay both the loan principal and interest for the use of that principal. Most loan arrangements make explicit statements about the term of the loan and the interest rates. However, some arrangements do not spell out the interest rate. A lease, such as for vehicles or equipment, contains an implied interest rate, while securities, such as bonds, measure their yield with an implicit interest rate.
Functions of Implied Interest Rate
The implied interest amount due is the difference between the loan principal and the total amount to be repaid. The implied interest rate is the implied interest due divided by the principal. For instance, if the principal of the loan is $10,000 and the borrower agrees to repay the loan in 12 monthly installments of $1,000 each, the total amount to be repaid is $12,000. The difference between the loan principal and the total amount to be repaid is $2,000, and the implied interest rate is 20 percent, or $2,000 divided by $10,000.
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Applications of Implied Interest Rate
For small businesses with bad or insufficient credit, leasing equipment is often the best option. These small businesses often encounter implied interest rates when leasing equipment. The implied interest is also known as the lease charge or rent charge. For vehicle leases, the dealer will often quote a money factor that determines the implied interest rate. By multiplying the money factor by 2.4, the business owner can get an accurate estimate of the equivalent annual interest rate.
Functions of Implicit Interest Rate
The implicit interest rate is an interest rate that is not specifically stated in a contract. With debt instruments, such as U.S. Treasury bills and corporate bonds, the implicit interest rate compares the current value of payments on a bond with the face value of that bond. For instance, a bond trader purchases a one-year Treasury bill for $10,000 on Jan. 1, 2014. The trader will receive $10,500 on Jan. 1, 2015, when the bond matures. The implicit interest amount received is $500 and the implicit interest rate is 5 percent, or $500 divided by $10,000.
Applications of Implicit Interest Rate
Although many bonds specify their interest rates, these bonds may also increase or decline in value between their issue dates and maturity dates. The implied interest rate represents the difference between the yield currently paid on a bond and the rate that the holder can expect to receive at the maturity date. The implied interest rate, rather than the rate stated in the bond contract, determines the true rate of return on that bond.