In finance, the interest rate is one of the most basic yet crucial concepts that every individual must know about. It has the power to shape the flow of money and is widely used by central banks to make economic decisions and control inflation. Whether you are a borrower or a lender, understanding what the rate of interest is and how interest is calculated is essential for effectively managing your finances. In this article, we are going to explore the meaning of interest rates, the types of interest rates, and how to calculate interest using simple mathematical formulas.
What is Interest Rate?
Interest rate, also known as rate of interest, represents the percentage of the loan or deposit that is charged or paid as interest each year. It is often expressed as an annual percentage of the principal amount of borrowing or deposit. For instance, if the interest rate on a 5-year loan of ₹5 lakh is 10% per annum, it essentially means that you will have to pay ₹50,000 each year for 5 years.
Lenders levy interest rates on loans and credit facilities for many reasons. The primary reason is that the interest component acts as a profit incentive for providing funds to the borrower. Also, lending money always comes with a risk of non-repayment. This is another major reason why interest rates are charged on loans. The interest component compensates lenders for the risk of lending money and the opportunity cost of not using that money elsewhere.
Different Types of Interest Rates
Now that you are aware of the meaning of rate of interest let us look at the different types of rates that are offered by financial institutions.
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Fixed Interest Rate
One of the most common types of interest rates, fixed interest rates remain constant throughout the entire tenure of the loan or investment. With these kinds of rates, the interest payments will remain the same for each period, making budgeting and financial planning a lot easier. Furthermore, since the rate of interest is locked in for the whole term, borrowers would be protected from interest rate hikes in the economy.
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Floating Interest Rate
Floating interest rates, on the other hand, change over the tenure of the loan or investment. These rates are based on a benchmark rate, such as the repo rate or the Marginal Cost of Lending Rate (MCLR). If there is any change in the benchmark rate, the floating interest rate will also fluctuate.
One of the primary advantages of floating interest rates is that they almost always start lower than fixed interest rates. If the interest rate in the economy falls, borrowers may benefit from lower interest payments. However, if the rates were to increase, they may face significant difficulties.
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Methods of Interest Calculation
Merely understanding the definition of interest rates is not enough to make effective financial decisions. It is equally essential to know the interest calculation methods that financial institutions usually employ. So, how does interest work? Here is a comprehensive guide to help you understand the concept.
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Simple Interest
Simple interest is calculated by applying the rate of interest on the principal amount. The mathematical formula that is used to calculate it is as follows:
Simple Interest = Principal Amount x Interest Rate x Tenure
Here is a hypothetical example to help you understand how simple interest is calculated.
Assume you borrow ₹1 lakh at an interest rate of 9% per annum for 2 years. In this case, the simple interest on the loan would be:
Simple Interest = ₹1 lakh x 9% per annum x 2 years
Simple Interest = ₹18,000
The total amount to be repaid can be calculated using the formula mentioned below:
Repayment Amount = Principal Amount + Simple Interest
Repayment Amount = ₹1,00,000 + ₹18,000
Repayment Amount = ₹1,18,000
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Compound Interest
Compound interest calculation is slightly more complex than simple interest. It involves calculating interest on the principal amount and the interest accumulated during previous periods.
To put it in simple terms, compound interest involves calculating interest on interest. While this could be highly advantageous for depositors since it can lead to faster investment growth, it can be a major drawback for borrowers as it would essentially increase the cost of borrowing.
The mathematical formula used for calculating compound interest is as follows:
Compound Interest = P [(1 + R/N)NT — 1]
Here, P refers to the principal amount, R refers to the rate of interest (converted to decimals), N refers to the number of times compounding is done in a year, and T refers to the tenure.
Let us use the same example as before to understand how compound interest is calculated.
Imagine you borrow ₹1 lakh at an interest rate of 9% per annum (or 0.09 in decimals) for 2 years. However, this time, the interest is compounded annually. You can calculate the interest by substituting these values in the above-mentioned formula.
Compound Interest:
= ₹1 lakh x [(1 + 0.09/1)(1×2)— 1]
= ₹1 lakh x [(1.092 — 1]
= ₹1 lakh x [1.1881 — 1]
Compound Interest = ₹18,810
As you can see, your interest burden increases by ₹810 (₹18,810 – ₹18,000) due to compound interest.
Common Factors Influencing Interest Rates
With this, you must now be aware of what interest rate means and how to calculate the interest component. Now, let us explore some of the most important factors that influence interest rates in the economy.
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Monetary Policy
The monetary policy of the Reserve Bank of India is one of the most influential factors that determine interest rates. An increase in the repo rate often leads to higher interest rates and vice versa.
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Inflation
Inflation in the economy also influences the rate of interest. When inflation is high, the interest rates are often hiked to reduce borrowing within the economy. Similarly, if inflation is low, the interest rates are reduced to stimulate economic activity.
Creditworthiness
The creditworthiness of the borrower determines the interest rate applicable to them. Borrowers with high credit scores of 700 and above are perceived as low risk and are offered low interest rates. On the other hand, borrowers with low credit scores typically face higher interest rates to compensate for the increased risk.
Conclusion
Whether you are taking out a loan or planning to save for the future, understanding what the rate of interest is and how interest is calculated is crucial for making informed financial decisions. Whenever you approach a financial institution for a loan, remember to keep in mind the various factors that influence interest rates. By staying informed about the current economic conditions, you can better equip yourself to make good financial choices that align with your goals and risk tolerance.
FAQs
Why is interest charged on loans and credit facilities?
Interest on loans and credit facilities acts as a profit incentive for lenders. Furthermore, it also compensates the lender for the risk they take by lending money to borrowers.
How does simple interest and compound interest differ from one another?
The difference between compound and simple interest is in the way the interest is calculated. Simple interest is only calculated on the principal amount. Compound interest, meanwhile, is calculated both on the principal and the accumulated interest from previous periods.
Why is the interest rate on personal loans higher compared to other loans?
Personal loans usually have higher interest rates than other loans due to the unsecured nature of the credit facility. Since there is no collateral backing the loan, the lender has to take on increased risk. To compensate for this increased risk, they levy a higher rate of interest.
What is the difference between APY and APR?
APY and APR are two terms commonly used in finance. APY is the acronym for Annual Percentage Yield and is used to represent the return from an investment or the cost of borrowing when compounding of interest is involved. APR, meanwhile, is the acronym for Annual Percentage Return and is used to represent the cost of borrowing without considering the effect of compounding.
How frequently are interest rates in the economy revised?
The interest rates in the Indian economy are set by the Reserve Bank of India (RBI). The rates are reviewed and revised each quarter of a financial year by the RBI’s Monetary Policy Committee (MPC).
