The Rate of Interest is the amount a lender (Banks/NBFCs/etc.) levies on a borrower for any debt given, typically a percentage of the principal amount to be loaned. The interest rate on a loan is usually calculated annually, known as the Annual Percentage Rate (APR).
The Rate of Interest is also known as the amount charged by a lender to a borrower on top of the principal for the borrower to use assets. The Rate of Interest can also be applied to the amount received by the banks/NBFCs/etc. from a savings account or Certificate of Deposit (CD). The interest which is earned on these deposit accounts is known as the Annual percentage Yield (APY).
The Rate of Interest also applies to the amount earned at a bank or credit union from a deposit account. Most mortgages use simple interest, but some loans use compound interest. The interest is applied to the principal along with the collective interest of previous periods. The borrower that is considered low risk by the lender will have a lower rate of interest, whereas the loan that is deemed to be high risk will have a higher rate of interest. Consumer loans usually use an APR, which means no compound interest is used. Savings accounts and CDs use the compound interest.
The Rate of Interest applies to the bulk of loan and borrowing transactions. People borrow money to buy houses, fund projects, establish or develop businesses, or pay for college tuition. Companies (Businesses) borrow money to support capital projects and grow their business by buying fixed and long-term assets like land, buildings, and machinery. Borrowed funds are repaid in whole on a specific date or in monthly payments. The majority of loan and borrowing transactions are subject to interest rates.
The Rate of Interest is directly proportional to the risk associated with the borrower. Interest is charged to reimburse for the asset’s loss due to its usage. Instead of distributing the money as a loan, the lender may have invested it in another company. The lender may have made money by using the item himself when it comes to lending assets. As a result, interest rates compensate for these missed possibilities.
When a lender considers a borrower low risk, the lender will generally charge a lower interest rate. If a borrower is deemed high risk, the interest rate paid to them will be greater, resulting in a more expensive loan.
An example of finding the Rate of Interest is –
If the borrower takes a loan of Rs.5,00,000/- from any bank and the rate of interest is 6%, which means you will have to pay to the bank the original amount of Rs.5,00,000/- + (6% x Rs.5,00,000/-) = Rs.5,00,000/- + Rs.30,000/- = Rs,5,30,000/-.
Fixed-Rate vs. Floating (Variable) Rate
Rate of Interest can be fixed, where the rate remains fixed throughout the loan term, or floating, where the rate is variable and can vary based on a reference rate.
Fixed-Rate
Fixed-rate loans shield borrowers from rising interest rates since they don’t alter if the reference rate increases. Furthermore, if the Rate of Interest declines, fixed-rate loans are worse for the borrower. For example, If the rate is 8% and the reference rate lowers. the borrower must continue to pay the 8% rate rather than the lower rate.
Floating-Rate (Variable)
Floating-rate loan protects the borrower from decreasing the Rate of Interest because the loan rate will adjust downward with the reference rate. In contrast, if the interest rate rises, this form of loan is bad for the borrower since their loan payments will grow in value (the reference rate increasing, resulting in a higher interest rate being paid).
Cost of Borrowing
There are two types of Costs of Borrowing:
- Simple Interest
- Compound Interest
Simple Interest
Simple interest is a fast and straightforward method to compute the interest payable on a loan.
Simple interest is computed by multiplying the daily interest rate by the principal, then multiplied by the number of days between payments.
Simple interest is calculated by multiplying the daily interest rate by the principal by the number of days that process between payments. Simple interest is usually applied to automobile loans or short-term loans; some mortgages also use this interest calculation method.
The formula for calculating Simple Interest is:
Simple Interest = Principal X Rate of Interest X Term of Loan
An example of finding the Simple Interest is –
Principal = Rs.30,000/-
Rate of Interest = 4%
Term of Loan = 2 years
Simple Interest = Rs.30,000/- X 4% X 2 = Rs.2,400/-
Thus, Total amount to be paid = Rs.30,000/- + Rs.2,400/- = Rs.32,400/-
Compound Interest
Compound interest (compounding interest) is the interest on a loan or deposit calculated using both the original principal and the interest accumulated over time. Compound interest, which is said to have originated in Italy (17th-century), is “interest on interest” and will cause a sum to increase quicker than simple interest, which is calculated on the principal amount.
Compound interest accrues at a rate decided by compounding frequency, with the higher the number of compounding periods, the higher the compound interest rate. Thus, during the same time, the amount of compound Interest accumulated on ₹1000 compounded at 10% yearly will be less than that on ₹1000 compounded at 5% semi-annually. Compounding is frequently referred to as the “miracle of compound interest” since the interest-on-interest effect can yield more positive returns based on the principal amount.
The formula for Compound Interest is:
Compound Interest = Amount (A) – Principal (P)
Amount (A) = P(1+)nt
Where,
A = Amount
P = Principal
r = Rate of Interest
n = Number of times interest is compounded per year
t = Time (in years)
Thus, Compound Interest (CI) = P(1+)nt – P
An example of finding the Compound Interest is –
Consider an amount of Rs.10,000/- is deposited at the Rate of Interest of 5%, which is compounded monthly, then the Compound Interest after 5 years to be –
P = Rs.10,000/-
r = 5% = = 0.05
n = 12
t = 5
Amount (A) = Rs.10,000/- X (1+) X 12 X 5 = Rs.12,833.58/-
Thus, Compound Interest (CI) = Rs.12,833.58 – Rs.10,000 = Rs.2,833.58/-
Factors Affecting Rate of Interest
Forces of Demand and Supply
The demand for and availability of credit in an economy impacts the Rate of Interest. Growth in credit demand eventually leads to an increase in interest rates or the cost of borrowing. On the other hand, growth in credit supply leads to a drop in interest rates. When the overall quantity of the money borrowed rises, so does the credit supply.
Inflation
Inflation means how expensive a set of goods and services has become over a particular time, usually a year.
Inflation is the rate at which prices increase over time. Inflation is usually defined as a wide measure of price increases or increases in the cost of living in a country.
The higher the rate of inflation, the higher the interest rate. This is because interest earned on money borrowed must account for inflation. The Lenders charge higher interest rates to reimburse for a decrease in money purchasing power, which will be repaid in the future.
Government’s Monetary Policy
The government’s monetary policy sometimes influences the amount of interest rates. In addition, as the government buys more securities, banks are given more money to lend with, lowering interest rates. When the government sells these securities, it takes money from banks, reducing their ability to lend and rising interest rates.