Interest and Interest Rates Explained

Interest rates are to asset prices what gravity is to the apple. When there are low-interest rates, there is a shallow gravitational pull-on asset price. - Warren Buffett


Often, we come across terms that are frequently used today, but the actual significance and meaning of those terms remain obscure to many.

The list comprises terms like investment and capital, GDP, trade deficit, etc. Seemingly, ‘interest rate’ is one such term. You might come across this term quite often- while watching the business news, seeing an advertisement about insurance, availing banking services, and various other situations.

What is interest and interest rate?

In the financial and economic spheres, ‘interest’ refers to the payments made by borrowers or financial institutions that receive or charge additional sums on loans or deposits on the primary amount borrowed, i.e., the principal sum. For example, customers typically pay interest on a bank loan, in which they spend the bank more than the amount owed to the bank. Alternatively, customers can save and therefore withdraw more than their previous deposits as well. In the case of savings, the customer plays the lender’s role, and the bank plays the recipient.

The ‘interest rate’ is the amount payable for each period in terms of each percentage of the amount lent or deposited (principal amount). The total interest on the amount taken or deposited depends on the principal amount, rate, compound and loan, term of deposit, and term of the loan.

How does it work?

Banks are primarily the fundamental entities that apply the interest rate on the financial transaction with their customers in the organised sector. Keep in mind that we do not include the rate used in unorganized sectors, usually in rural areas, although they work in the same way. It works in two ways:

Borrowing

The interest is applied to any money you borrow from a bank or a financial entity. Any loan is sanctioned on the assurance of the borrower’s repayment of the loaned amount. Besides, to compensate the lender for the risk of lending the money, more amounts than borrowed have to be paid back.

Lending

Interest is applied when lending money as well. If you have surplus capital, you can invest that money by lending or depositing it in a bank with the hopes of earning interest.

Banks charge interest on the entire balance of your loan or credit lines taken from them, and part has to be paid in predefined periods (SI and CI). Failing to make payments increases the debt despite paying the loan’s principal amount. This is because its collection from borrowers is a primary source of capital inflow for banks and financial entities that provide loan credit lines to customers.

If a bank thinks that the debt is less likely to be repaid from the borrowing party, it charges higher rates. As a result, banks apply higher rates on revolving loans, which means loans like credit cards, as these loans are more expensive to manage. Banks also charge higher rates from people who they deem as risky. Effectively, the higher your credit score, the lower the interest rate. A credit score represents your creditworthiness, i.e., your capability to repay a loan taken from banks.

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Interest rate is the amount payable for each period in terms of each percentage of the amount lent or deposited- principal amount.

Payment or gain of interests depends on the following points:

Rate
Amount of the loan
Repayment period

A higher rate or a longer-term loan amounts to the borrower paying more.

Earning

If the funds are borrowed or deposited in a bank account with interest-bearing facilities like a savings account, you can earn it. Banks do the lending on your behalf with your money: they use your money to lend to other customers and make additional investments. Eventually, they pay a portion of their profits in the form of interest to you.

Banks regularly pay interest on your deposits. You will see interest payment transactions and notice in your account balance increase over time. You can spend this money or save it on your account to continue earning interest.

Let’s understand this with an example.

Suppose you deposit Rs 1,000 in a savings bank account with a 5% interest rate service available. With simple interest, you’d earn Rs 50 in a one-year period. To calculate:

Multiply Rs 1,000 in savings by 5%

Rs 1,000 x .05 = Rs 50 in earnings

Account balance after one year = Rs 1,050.

However, most banks calculate interest income for every year, not just for a year later. It can be used because these compounded gains are useful to you. Compound interest will work something like this-

Your account balance would be Rs 1,051.16 after one year.

Your annual percentage yield (APY) would be 5.12%.

You would earn Rs 51.16 over the year.

The difference seems small here, but the amount taken as an example here is only Rs 1000. For every Rs 1000, more interest will be earned. Over time, as more money is increased, the process will continue to yield more prominent and more significant rewards. If you leave your account, you will earn 53.78 rupees the next year, up from 51.16 rupees the first year.

Paying

Interest can be applied to different types of business or personal transactions, a few of which are mentioned below:

Payment of Debt in Instalments

In addition to secured loans such as homes, cars, and student loans, monthly payments are often consistent with interest costs. Every month, part of the first payment reduces debt, and the amount of it adds to the payment costs. With these loans, you pay off your debt within a certain period. For example, a 15-year house loan or 5-year vehicle loan will include repayment of the original amount borrowed plus interest on the amount gathered over time.

Revolving Debt

A revolving loan is a loan that lets you borrow every month, and you can repay your debt regularly. For example, if you are using a credit card, you can reuse it, given that the transactions are within the credit limit. There are many ways to calculate interest, but it is not difficult to understand how to pay interest in revolving debt payments.

Additional Costs

Loans are generally valued at an annual interest rate. This number indicates the annual rate and may include additional charges to the sum accumulated. Net rate expense corresponds to part (not annualized).

Types of Rates

Simple (Regular) Interest- SI

It is calculated by multiplying the daily interest rate by the number of days between payments.

Formula is:

SI = Principal x I x Rate x Time, i.e., SI = P x R x T

For example, if an individual takes a loan for Rs 3 00,000, her/his SI on the loan at the term of the loan for, say 20 years, will be:

SI= Rs 3, 00,000 × 15% × 20= Rs 9, 00,000

This means, after 20 years, the lender will get Rs 9, 00,000.

Compound Interest Rate – CI

Some lenders prefer the CI on loans as it results in the borrower paying a higher rate. CI is also called an ‘interest on interest’ as it is applied to the principal and interest previously collected.

The CI paid at consolidation is higher than the standard SI rate method. Sum is paid monthly on the principal, including interest collected in previous months. The flat rate is the same for both ways (simple and compound) in the short term. However, as the loan grows, the gap between the two types of interest rates widens.

The formula for CI => p × [(1+rate) n−1]

Where: p=principal, n=number of compounding periods

If you are saving money using a savings account, CI is favourable. It includes the interest accrued on these accounts and allows the account holder to pay the bank using these deposits.

For example, if a business deposits Rs 5, 00,000 into a high-return savings account, the bank can take Rs 3, 00,000 of these funds to use as a mortgage loan. To compensate the business, the bank pays 6% into the account annually. So, while the bank is taking 15% from the borrower, it gives 6% to the business account holder, or the bank’s lender, totalling it at 9%. In a nutshell, savers lend the bank money, which, in turn, provides funds to borrowers in return for a stake.

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Banks do the lending on your behalf with your money: they use your money to lend to other customers and make additional investments.

Conclusion

Therefore, it can be concluded that interest plays a chief role in the finances of all types of businesses, either new or well established. As we have learned, when consumers pay less in interest, this gives them more money to spend, which can create a booming effect of increased spending throughout the economy. This is how big of role interest rates play in the economic setting of a country.

Read more about financial topics like GDP, GST, EBITDA and others on our website.

Aakash Sharma
Aakash Sharma
Aakash writes on Startup Ecosystem, Policies, Legal and Regulatory aspects of business planning. An alum of Delhi University, he is assistant editor at Dutch Uncles.

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