Interest Rate: Definition, How It Works, Examples
Ever wondered why borrowing money sometimes feels expensive, while at other times it seems more manageable? The answer lies in interest rates, a key aspect that affects almost every financial decision, from taking out a loan to earning interest in a savings account. Simply put, an interest rate is the cost of borrowing money, expressed as a percentage of your loan amount. It’s how lenders earn profit by lending you money, whether it’s a car loan, a home loan, or a personal loan.
But interest rates aren’t the same for everyone. They can vary depending on the bank and the loan agreement, the type of credit, and broader economic factors such as RBI monetary policy. Understanding the different types of interest rates and how interest is calculated can help you make smarter decisions and take control of your finances.
What is an Interest Rate?
Interest rate is the percentage of the loan amount you pay the lender when borrowing money. You must pay it over and above the original amount you borrowed, which is your principal plus interest. Similarly, if you deposit your money in a bank or financial institution, they pay you interest on the funds you deposit.
When you borrow money at a high interest rate, the total interest makes the loan expensive, and you end up paying a hefty sum above the borrowed amount. On the other hand, when interest rates are low, loan costs decrease and borrowing becomes easier.
How Interest Rates Work When Borrowing?
When borrowing money, you must repay the principal to the lender, along with the interest charged. Typically, it is the annual percentage of the loan amount that is charged. You may obtain credit in various forms, including Personal Loans, Home Loans, Car Loans, Mortgage Loans, Credit Cards, and more.
For instance, if you borrow Rs 1 Lakh from a lending institution at a 19% interest rate per annum for three years, you will end up paying approximately Rs 1.32 Lakh by the end of the term. The lender will collect your repayment in monthly instalments of about Rs 3,666.
Also Read: Penal Interest: Meaning, Definition & How It Is Calculated
Types of Interest Rates
Now that you know what interest is, it's time to learn about its types. Here's an overview:
Simple Interest Rates
| Definition | Details |
|---|---|
| Definition | A simple interest rate computes interest on the principal amount, considering the loan term for that year only. The lender charges interest each year on the same loan amount without compounding. |
| Formula | Principal Amount × Interest Rate × Time (in years) / 100 |
| Example | If you borrow Rs 50,000 for two years at an interest rate of 19%, the calculation will be: = 50,000 × 19 × 2 / 100 = Rs 19,000 So, the total simple interest you pay over two years will be Rs 19,000. |
Compound Interest Rates
| Definition | Details |
|---|---|
| Definition | The lender continually calculates the interest rate on the principal amount plus the interest charged for the last payment period. It increases the loan cost by compounding the interest from previous terms. |
| Formula | P×((1+r)n−1) Compound Interest = P×((1+r)n−1) Where: P = Principal amount r = Interest rate per period (in decimal,) n = Number of periods (years) |
| Example | If you borrow Rs 50,000 for five years at an interest rate of 19% per annum, the calculation will be as follows: First year interest: 50,000×19/100 = Rs 9,500 Second year principal + interest: 50,000 + 9,500 = Rs 59,500 Second year interest: 59,500×19/100 = Rs 11,305 (added to previous total) This process continues for each year, as the interest is calculated on the principal plus interest from the previous year. |
Fixed Interest Rate
| Definition | Details |
|---|---|
| Definition | The fixed interest rate remains the same throughout the loan tenure, so the interest rate on the loan stays predictable from start to finish. This means your Equated Monthly Instalments (EMIs) usually remain constant throughout the repayment period. Most conventional loans follow this fixed structure. |
| Formula | Principal x Rate of Interest x Period divided by 100 |
| Example | If you borrow Rs 1 Lakh for two years at the interest rate of 6%, the interest payment will be Rs 12,000 |
Variable or Floating Interest Rate
| Definition | Details |
|---|---|
| Definition | Variable rates, or floating rates, change based on the repo rate set by the Reserve Bank of India (RBI). These changes follow the monetary policies of the RBI. As a result, your loan interest rates can change during the tenure, impacting your EMIs and total loan repayment. |
| Formula | Floating Interest Rate (%) = Base Rate + Spread |
Also Read: What Is The Difference Between Fixed And Variable Loan Interest Rate?
APR vs. APY
APR, or the Annual Percentage Rate, is the interest rate offered by lenders and shows what you pay when you take out a loan. APY, or the Annual Percentage Yield, is the interest earned on your bank deposits. Both are expressed as a percentage, but they work differently. APR uses simple interest, while APY uses a compounding method.
A lower APR is better because it reduces the amount of interest you pay on a loan. A higher APY is better because it increases the interest you earn each year on your savings.
Also Read: Reverse Repo Rate: Meaning and How It Works?
How do Lenders Determine Interest Rates
On applying for a loan from the bank or an NBFC, the lenders decide interest rates by looking at your income, existing debt, and overall ability to repay. This helps them judge how safe it is to offer you credit. The interest rate on the loan also depends on the type of loan you take, such as a Home Loan, Personal Loan, or Auto Loan.
For example, if you take a Personal Loan amount of Rs 5 lakh, the lender calculates the total cost and adds interest to make a profit. If the personal loan interest rate is 10%, you will pay 10% of Rs 5 Lakh, which is Rs 50,000. So your principal plus interest becomes Rs 5,50,000.
Also Read: Reducing Vs Flat Interest Rate: Know The Difference
Factors Affecting Interest Rates
Lending institutions consider several factors in determining your loan interest rate, including the following:
Inflation Rates
When inflation increases, interest rates rise. The RBI raises interest rates to reduce loan demand and spending, helping to control price rises (inflation) in the economy.
Market Demand and Supply
When more people want loans at the same time, the market interest rate tends to rise. When this happens, fewer people borrow, and the economy gradually balances out.
Government Debt
When lenders have to pay a higher repo rate to the RBI, they pass that cost on to borrowers. This is influenced by monetary policies, which guide how interest rates are set in the country.
Economic Conditions
Changes in the economy and global events can affect how much lenders charge. Interest rates will affect how easily people can borrow during uncertain times by encouraging or discouraging loan demand.
Credit Scores
A higher score shows that you borrow and repay responsibly, so lenders may offer you a lower rate. A lower score often leads to a higher cost because the interest rate is the amount lenders charge to cover their risk.
Conclusion
After understanding the relevance and meaning of interest rates, you can see how central they are to any loan. They influence key financial decisions, whether you’re borrowing, investing, or saving. Knowing what interest rates are, their types, and how they work helps you make informed choices and manage your money with confidence.
Frequently Asked Questions
What are the different kinds of interest rates?
The main types of interest rates in India include fixed, floating (variable), simple, and compound interest.
How do fixed and floating interest rates differ?
A fixed rate stays the same for the entire loan or deposit period, making repayments predictable. A floating rate can increase or decrease over time based on market conditions, which means your monthly payment may change, too.
How do interest rates affect loans and savings?
Higher interest rates usually mean loans become more expensive, while savings grow faster. Lower rates make borrowing cheaper, but they also reduce the returns you earn on savings.
What is the difference between the interest rate and the APR?
The interest rate is the basic cost of borrowing. APR includes the interest rate plus other charges or fees, giving you a clearer picture of the total cost of the loan.
How do the central bank's policies influence interest rates?
Central banks adjust benchmark rates to guide economic activity. When they raise rates, borrowing slows down. When they cut rates, borrowing becomes easier, which can boost spending and investment.
What is the significance of the repo rate?
The repo rate is the rate at which the RBI lends money to commercial banks. When the repo rate goes up, banks usually raise their lending rates. When it drops, loans often become cheaper.
Can credit scores influence interest rates on loans?
A higher credit score shows lenders you’re reliable and can help you secure a lower interest rate. A lower score signals more risk, which often leads to higher rates.
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Disbursement
The act of paying out money for any kind of transaction is known as disbursement. From a lending perspective this usual implies the transfer of the loan amount to the borrower. It may cover paying to operate a business, dividend payments, cash outflow etc. So if disbursements are more than revenues, then cash flow of an entity is negative, and may indicate possible insolvency.