What we could purchase with Rs. 100, ten years ago is not the same today. So, while discussing money, it is essential to correlate it with a time since an amount of money will have a varied worth depending on the moment we are referring to.
As a result, banks and other financial institutions developed interest rates to incorporate the concept of time into loan and savings calculations. If a bank lends Rs. 1,000 for two years and the consumer returns the same Rs. 1,000, the amount is not worth the same as the Rs. 1,000 from two years earlier.
An interest rate is the cost of borrowing money or saving money. It is determined as a percentage of the sum received from an individual, bank or financial institution.
Read along as we discuss more about interest rates and their types.
What is Interest Rate?
The interest rate is the amount charged by a lender to a borrower and is expressed as a percentage of the principal amount—the amount given as a loan. This rate is often expressed as an annual percentage rate (APR).
APR is the annual percentage rate that is imposed over a year. Interest rates can be imposed across a variety of periods, including monthly, quarterly and biannually.
Basically, interest is levied to compensate the asset for the loss created by use. In the case of lending money, the lender may have invested the funds in another venture rather than making a loan. In the instance of lending assets, the lender may have earned money by using the asset himself. As a result, interest rates are used to compensate for these lost opportunities.
An interest rate can also be used for the amount earned from a savings account or Fixed deposit (FD) at a bank or corporate. The income generated on these deposit accounts is referred to as the annual percentage yield (APY).
Example
Ravi asks his bank for a home loan of Rs. 50,000, which he will pay back in 5 years. The bank agrees and says that till the time he pays it on time, the interest will be calculated on simple interest. Otherwise, it will be calculated on compound interest at a rate of 8%.
Now, let's calculate both his simple and compound interest payable. First, we'll calculate simple interest:
Interest Payable = Principal* Rate*Time
Interest Payable= 50,000 *0.08*5
Interest Payable = 20,000
This means that if Ravi pays back his loan to the bank on time, he'll have to pay Rs 70,000 (50,000 + 20,000.)
Now, let's calculate the amount based on the compound interest:
Interest Payable = Principal*(1+ Rate) ^T
Interest Payable = 50,000 (1+0.08) ^5
Interest Payable = 50,000 (1.08) ^5
Interest Payable = 23,466.40
This means that Ravi has to pay Rs 73,466.4 (50,000 + 23,466.4)
What are the Factors Affecting Interest Rates?
Interest rates are crucial economic indicators that influence borrowing costs, investment returns and overall economic activity. They are determined by various factors, including:
Demand for and Supply of Money:
When the demand for money exceeds the supply, interest rates tend to rise, as lenders charge higher rates to attract more borrowers. Conversely, when the supply of money exceeds the demand, interest rates tend to fall as lenders compete to attract borrowers by offering lower rates.
Inflation:
A general increase in prices over time erodes the purchasing power of money, leading lenders to demand higher interest rates to compensate for this loss of value.
Monetary Policy:
By increasing the money supply, RBI can lower interest rates and by reducing the money supply, it can raise interest rates.
Credit Risk:
Lenders consider the creditworthiness of borrowers when determining interest rates. Borrowers with higher credit risk, typically those with a history of late payments or defaults, face higher interest rates to compensate lenders for the increased risk of non-payment.
Global Economic Conditions:
These conditions can also influence interest rates. For instance, if economic growth is slowing or inflation is rising in major economies, it can impact interest rates in other countries as well.
Time Horizon:
Interest rates for loans of different durations vary depending on market expectations about future interest rates and inflation.
Loan Type:
Longer loan terms generally have higher interest rates than shorter terms, reflecting the increased risk of default over a longer period.
Types of Interest Rate
The four main types of interest rates are:
Compound Interest
Compound interest is a more complex type of interest that takes into account the interest earned on the principal amount as well as any accumulated interest. This means that the interest rate is applied not only to the principal amount but also to the interest that has already been earned.
Also, this can lead to exponential growth over time as the interest earned on the interest becomes more significant. The formula for compound interest is:
A = P (1 + r)^t
Simple Interest
Simple interest is the most basic type of interest, calculated on the principal amount only and accrues at a constant rate over the loan or investment period. Unlike compound interest, which considers the interest earned on both the principal amount and accumulated interest, simple interest only considers the principal amount and the interest rate.
It's calculated using the following formula:
Interest Payable = Principal* Rate*Time
Fixed Interest
Fixed interest is a type of interest rate that remains constant throughout the loan or investment period. This means that the borrower or investor knows exactly what their interest payments will be for the duration of the agreement.
Usually, fixed interest rates are used for mortgages, auto loans and other types of loans where the repayment schedule is fixed.
Variable Interest
Variable interest is a type of interest rate that can change over time, typically in response to changes in the benchmark interest rate. The benchmark interest rate is the interest rate set by a central bank, such as the Reserve Bank of India (RBI).
Variable interest rates can be risky for borrowers and investors, as they can increase their monthly payments or reduce their return on investment if the interest rate rises. However, they can also be beneficial if the interest rate falls.
What is the Interest Rate on Borrowing and Deposit?
The interest rate on borrowing is the percentage of the principal amount that a borrower needs to pay to the lender as compensation for the use of the money.
Unlike interest on borrowings, the interest rate on deposit is the percentage of the principal amount that a depositor earns on the money that they have placed in the bank. This rate varies depending on the type of account, the amount of money deposited, and the length of time it is deposited.
The interest rate on borrowing is typically higher than the interest rate on deposit because the lender is taking on more risk. When a borrower borrows money, they are promising to repay the loan with interest, and there is a risk that they may not be able to do so. The lender is, therefore, compensating the borrower for this risk by charging a higher interest rate.
Also, in the event of a default, banks or financial institutions cease charging interest and reclassify the assets on their accounts. Whereas, in the event of prepayment, the borrower is charged a penalty and interest to avoid the loss of regular income due to the time value of money.
How Does Interest Rate Differ from Interest Type?
Interest rate type differs from interest type in terms of how frequently interest on borrowed funds is compounded. Also, the method by which interest is computed varies, such as whether it is modified or compiled on a daily, monthly or annual basis.
In either case, the percentage will vary – these work by applying the loan's outstanding principal each year. The length of time that interest is charged will also vary and might be daily, monthly or yearly.
On top of that, an interest rate definition can vary depending on elements such as the consumer's particular credit score. A person with a good credit score, for example, will be authorized for loans with lower interest rates than someone with a bad credit score. This is due to the lender taking on more risk by lending money to someone who may be unable to repay it.
So, when looking for a loan and researching interest rates, make sure to inquire about the interest kind as well, so you know precisely what you're getting into and how much you'll be paying.
Wrapping Up
An interest rate is the cost of borrowing money or saving money. Interest rates are managed by each country's central bank and are determined by taking the economy, inflation, risk, and loan length into account.
Interest rates have been around for a long time now and are an important aspect of the economy because of people's need for resources and the existence of persons or institutions willing to lend money.
Frequently Asked Questions
What are Rates of Interest?
The rate of interest is the percentage of the principal amount that is charged as interest for borrowing money. It is typically expressed as an annual percentage rate (APR). The higher the interest rate, the more you will have to pay back in interest over the life of the loan.
What is the Interest Rate Formula?
The interest rate formula is:
Interest Paid= Principal * Rate * Time
Why is it Called Interest Rate?
The interest rate is called so because it is the rate at which interest is charged. Interest is the money that is paid to the lender for the use of the borrower's money.
What is Interest Income?
Interest income is the money that is earned on savings accounts, Fixed deposit (FDs), and other investments. It is typically expressed as an annual percentage yield (APY). The higher the APY, the more money you will earn in interest over the life of the investment.
