Interest rate refers to the amount that a lender charges from the borrower over the amount borrowed. Interest rate play a huge factor in borrowing funds as they determine the cost a lender needs to bear. Higher interest rate means high cost which makes the transaction expensive. On a different note, Banks provides interest on savings account helps the account holder to earn extra money on the principal amount that he/she has deposited or you can consider interest rates as a return against your deposit amount. This phenomenon is the reason why more people prefer to deposit their money in banks.

What is Interest rate?

Interest rate is an amount charged on the asset borrowed. Assets can be cash, vehicle, consumer goods etc. It is often called the cost of using an asset.

Interest rates are charged on most borrowing or lending transactions. Funds are borrowed on various accounts such as for building a house, education, business purposed etc. The borrowed money is then repaid in lump sum or periodic instalments according to the contract established between the lender and the borrower.

Why are Interest rates higher or Lower?

• Interest rate depends on the duration of the deposit and the credit score of the lender. When the credit score of a person is lower which means the probability of the lender returning the money is lower, a higher interest rate is charge due to the risk associated.
• Lower interest rate is charged when the duration for which the money is borrowed is less and the credit score of the person is high, i.e., the probability of the lender returning the money is higher.

Therefore, the magnitude of the interest rate depends upon the duration of the deposit as well as the risk associated. Higher interest rates often signify higher risk and longer duration and vice versa.

Understanding Simple Interest and Compound Interest

Simple interest refers to the rate of interest that is applied on the principal amount that is borrowed.

For example – If you loan out Rs 2,00,000 from a bank with an agreement to pay 10% interest annually for 2 years (the duration for which the loan is taken), the total interest that you need to pay is 40,000, which further means the total amount that need to be repaid by you will be Rs 2,40,000.

SI = Principal * Rate* Time

                     100

Compound Interest refers to the amount of interest charged on the principal and the accrued interest. Compound interest is always higher than simple interest because it is not just levied on the principal amount but also on the accrued interest of previous year(s).

   For example – If you loan out Rs 2,00,000 from a bank with an agreement to pay 10%        interest annually for 2 years (the duration for which the loan is taken), the interest for first year will be Rs 20,000 and on second year the interest will extend to Rs 22,000 because interest would be levied on Rs 2,20,000 (Principal plus interest of first year). Therefore, the total amount payable will be 2,00,00 + 20000 + 22000 which equals to Rs 2,42,000.

CI = Principal [1+Rate/100]^time – Principal

It is clear from the example that Compound interest will always be greater than simple interest.

What are the factors that determine Interest rate?

1. Forces of demand and supply

Due to fast growing and competitive economy, the demand for money increases. Investors require money for investment and competition  purposes, businessmen for funding short term and long-term business projects and citizens for buying houses, higher studies etc., and since the demand for money rises, the interest rate shoots up to increase the cost of borrowing funds to combat the problem of inflation. As we know that when money is easily available to meet all the demands it leads to increase in the flow of economy which further leads to inflation. Hence, demand has an inverse relation with interest rate.

When supply of money is tight which means there are less funds available for general public to borrow, interest rate shoots up to make borrowing costly. Hence, supply has an inverse relation with interest rate.

• Inflation

Higher inflation rate leads to higher interest rate. This happens because lender needs to compensate for the decrease in purchasing power of the money that will be repaid in the future. For example – If the inflation rate increases to 10%, Rs 1000 will be equal to 1100 next year. Hence, to compensate for the loss of Rs 100 is this process, lenders charge high interest rate.

• Government

Government uses various monetary policies to influence interest rates. One of such policies is open market operations. When government buys a large number of securities, it increases the supply of money in the economy as now more funds in available with the banks. On the other hand, when government sells securities, it leads to a decrease in supply of money as now most of the fund is used to pay the government, depleting the overall fund. This is how government uses its policies to control demand and supply which in turn controls the interest rate.

Real and Nominal rate

There are two types of interest rates – Real and Nominal.

Nominal rate does not take inflation into consideration and simply represent the rate that a person will receive on their deposit/lent fund. It subtracts the need to access fund on the basis of its value on the day of repayment, as the purchasing power during the time when money was deposited/borrowed will differ from the day when the same money was repaid.

Real rate takes inflation into consideration. It presents the real picture of the purchasing power of the sum deposited/borrowed on the day of repayment in comparison to the day when it was deposited/borrowed. This helps to access the real value of funds and make informed investing decisions.

For examples – a person earns 8% interest rate on a fixed deposit made for 2 years but inflation increased to 10% during this time, so actual earning is 8% – 10% which equals to a loss of 2%. Thus, in reality he is losing the purchasing power of his deposit by 2%.

Therefore, real rate is calculated by subtracting the inflation rate from nominal interest rate.

To summarize, interest rate is determined by a number of factors and is extremely instrumental in making profitable as well as informed investment decisions.  Both borrowers and lenders need to have the understanding of the mechanism of interest rates so they don’t lose value and utilize their funds in the most lucrative way.