What is interest rate?

Read on to know about interest rates, their types and the factors that influence interest rates.
What is interest rate?
5 min read
08 Dec 2022

An interest rate is a percentage charged on the loan amount that you have borrowed. It is imposed by the lender over and above the principal loan amount. Your Equated Monthly Instalment (EMI) is based on the borrowed amount, the interest rate, and the tenure of the loan.

Types of interest rates

There are different forms of interest rates, here’s all about them and how they work:

Fixed interest rate: The most common type of interest rate is a fixed rate, which is usually what the lender charges the borrower of a personal loan. As the name suggests, the interest rate stays the same throughout the loan's repayment period. When a loan is given, the lender and the borrower usually agree on the interest rate.

Variable interest rate: A variable interest rate is the opposite of a fixed interest rate. In this situation, the interest rate changes over time based on several factors like repo rate. Variable interest rate is typically linked to changes in the base interest rate, also known as the prime rate of interest. Variable interest rates are usually seen in the case of home loans.

Compound interest rate: The term "interest on interest" refers to the compound interest rate method. Here, banks will first apply the interest to the loan amount, and then interest is also charged on the interest accrued. Most loan products use this method of calculating interest in conjunction with a fixed or floating type of interest. Given that the interest charged is compounded, it usually is more expensive compared to simple interest.

Simple interest rate: As the name rightly suggests, a simple interest simply calculated at a fixed rate on the borrowed amount. It can be easily calculated by multiplying the principal, the interest rate, and the tenure. This method of calculating interest is not often used by banks and financial institutions on a personal loan.

Some of the factors that influence personal loan interest rates are listed below:

  • Monthly income
  • Debt-to-income ratio
  • Credit score
  • Economic conditions and other market factors
  • Employment stability
  • Relationship with the lender

Borrower’s cost of debt

Interest rates are a cost to the borrower, but they are a source of income for the lender. Companies compare the cost of borrowing with the cost of equity, such as dividend payments, to figure out which source of funding is the least expensive.

Difference between APR and APY

Consumer loan interest rates are usually given as the Annual Percentage Rate (APR). This is the rate of return that lenders want in exchange for lending their money. On the other hand, the interest rate on a savings account or cash deposit at a bank or NBFC is called the Annual Percentage Yield (APY). Compounding is taken into consideration in this interest rate.

Reasons for changes in interest rates

Short-term political gain: Lowering interest rates can give a short-run boost to the economy and may influence the overall sentiment of the masses and thereby have an indirect impact on the elections. But most economists think that lowering interest rates will only give a temporary boost to the economy that will soon be cancelled out by inflation.

Expectations of inflation: Interest rates are heavily influenced by expectations about inflation. Higher inflation expectations cause rise in interest rates, while lower inflation expectations cause rates to fall. While making monetary policy choices, such as adjusting interest rates, to accomplish their inflation targets, central banks also regularly track inflation expectations.

Taxes: Taxes can affect interest rates by changing the supply and demand for loans. When taxes are raised, there may be a decline in the need for loans. This drop in demand can lead to a lower interest rate, since lenders are competing for fewer borrowers. On the other hand, when taxes are reduced, individuals and businesses have more disposable income, which increases the need for loans. Overall, changes in taxes can affect the total amount of borrowing and lending in an economy, which can influence interest rates.

Economy: Interest rates vary depending on the economy. Interest rates tend to rise when the economy is strong and fall when it is weak.

Factors determining the interest rates

Economic conditions are the primary reason for the rise or fall in interest rates. Some other factors including inflation, stock market conditions, international investments, fiscal deficits, etc. influence the interest rates as well. Each financial institution uses these rates to figure out the APR range they offer. When the central bank raises loan interest rates in India, the cost of borrowing money goes up. When the cost of borrowing is high, people are less likely to borrow, and consumer demand goes down.



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