On a personal level, we are all familiar with home loan interest rates, which impact us directly. In a larger context, interest rates are instrumental in steering the course of the global economy—be it economic growth or a slowdown in growth. Let’s dig in.
Understanding interest rates
In the financial world, interest rates refer to the cost of borrowing money and returns offered on depositing money with a bank or financial institution or investing in debt securities.
Interest rates are always expressed in percentage terms and are calculated on an annual basis. Therefore, if you are a borrower, the interest rate is the amount of money the lender charges on the loan amount. And if you are a saver, the interest rate is the amount paid on the funds you have deposited in a bank or a financial institution.
The higher the interest rate, the higher the sum charged from the borrower, or the higher the money offered to savers.
Interest rate on borrowings
The interest rate on borrowings is the cost of borrowing, which the lender charges on the amount lent. Most lenders use a simple interest formula on the outstanding loan amount to calculate the interest on the borrowed money or principal amount.
For example, @ 8% home loan interest rate, the annual interest cost on ₹5 lakh home loan will be ₹40,000, and as and when the principal amount is repaid, the interest cost will be calculated on the outstanding loan amount. In the first year, after making ₹50,000 in principal repayment, the home loan interest rate in the second year will be ₹36,000.
If you are repaying through EMI (equated monthly installments) mode, banks calculate interest on a monthly basis.
Interest rates on deposits
You can earn interest rates on deposits by keeping money at the bank or any central bank-registered financial institution.
In India, a depositor gets interest income in his account at the end of the financial year or semi-annually. In the case of term deposits/fixed deposits, banks or financial institutions calculate compound interest annually until the deposit matures.
The interesting tidbit is that the interest rate on your savings bank account is calculated daily based on the closing balance, and the amount is credited to your account semi-annually or quarterly.
Different types of interest rates
There are two different approaches to calculate interest on the principal amount: simple interest formula or compound interest.
Banks calculate simple interest on the principal amount borrowed or lent over a fixed period. It is the most straightforward way of calculating the interest portion. The formula to calculate simple interest is:
Simple interest= P×R×T
R=Annual interest rate
T=Term of loan, in years
For example, the FD interest rate offered on a one-year deposit is 8.2%. Then on a sum of ₹ 1 lakh, the simple interest for a time duration of 8 months is calculated in the following manner:
Simple interest= 1,00,000 × 8.2% × (8/12) = ₹ 5,466
The only difference between compound interest and simple interest is that compound interest allows interest calculation on the accumulated interest of previous periods. The formula to calculate compound interest is:
Compound Interest=P×(1+r)^t −P
r=Annual interest rate
t=Number of years interest is applied
Continuing with the simple interest example, suppose you want to continue the deposit for three years. The total interest earned will be:
Compound interest= 1,00,000 × (1+ 8.2%)^3 − 1,00,000 = ₹ 26,672.34
Calculating compound interest is a bit complex as it involves a lot of calculations. Using an online compound interest calculator will help you calculate the amount instantly.
What are APR and APY?
APR stands for annual percentage rate, and APY stands for annual percentage yield.
Whenever you borrow money from a bank or financial institution, the home loan interest rate advertised is not the final borrowing cost. Other borrowing costs, such as processing fees, taxes, and service charges, increase the cost of borrowing.
Therefore, to know the total cost of borrowing, you should always insist on the APR or the annual percentage rate. It includes all costs, including the interest rate, in borrowing money from the lender. APR is the interest rate in percentage terms.
APY refers to the actual rate of return on the deposit after considering the effect of compounding. Compared to the interest rate offered on deposit tenure of more than one year, APY is always higher and often expressed in annualized returns.
What are the factors that affect interest rates?
The following are the three major factors that influence interest rates.
Liquidity is the ease with which an asset can be converted to cash, largely in accordance with its market price. If the demand for money is higher and the supply is lower, central banks increase interest rates to balance the money supply in the market. Lower borrowing costs increase the supply of money in the market, often leading to inflation. In such a situation, central banks raise interest rates on borrowing to lower the money supply in the economy.
Similarly, when the market situation is favorable and inflation is under control, central banks lower interest rates to push for economic growth. The most important factor that affects the interest rate is the level of inflation in the economy.
Fiscal deficit and government borrowing
Fiscal deficit refers to excess government spending compared to revenue. To fund the deficit, governments resort to market borrowing through the issue of sovereign debt. The higher the fiscal deficit, the higher the borrowing rate because it creates a demand for money in the market and influences the interest rate.
A higher fiscal deficit always results in an uptick in bond yields in the market.
Global interest rates and foreign exchange
One of the key tasks of central banks is to keep the foreign exchange rate of local currency stable. Higher interest rates in developed countries often lead to a huge outflow of foreign funds deployed in the economy, resulting in local currency depreciation. Therefore, to keep foreign exchange rates within the targeted range, central banks keep tabs on national interest rates vis-a-vis global rates.
Interest rates influence not only individual borrowing and savings, but have a bearing on economic growth as well. On a personal level, understanding different interest rate cycles would help you make the right investment decisions for the short- and long-term.