The rate of interest in general, is the price we pay for borrowing money. It is the price that the lender charges for taking the risk and investing in the money market. If you borrow/take a loan from the bank for personal requirements like buying a house or car or starting a business, you will have to pay interest to the bank on your loan. If you deposit money in a bank in the form savings or fixed or recurring deposits, the bank pays you interest for the use of your money.
The simplest theory of interest rate determination is that of the classical approach. According to the classical approach, equilibrium rate of interest is that rate where investment is equal to savings in the economy (assuming perfect full employment of labour and capital in the economy). The modern theory takes into account the balance of four factors- investment, savings, and demand for money and supply for money, to reach the equilibrium rate of interest.
These theories give a general perception of why a certain rate of interest prevails in the economy at a given point of time.
How do banks calculate interest rate
Banks use a formula to calculate the interest amount you will have to pay. The standard formula for computing simple interest is- Principal x Rate of interest x Time. If you borrow Rs. 10000 at an annual interest rate of 6% for a period of 1 year, the interest amount you pay will be Rs. 600. 10000 (Principal balance) x 0.005 (monthly interest rate) x 12 (no. of months)
The monthly interest rate is calculated as follows-
- The decimal equivalent of 6% is 0.06
- 0.06 is divided by 12 equals which is 0.005.
So the total amount you pay back to the bank at the end of the year would be Rs. 10600 (principal + interest).
This is simple interest when the principal is paid all together at the end of the loan period. The interest rate and the amount of total interest paid are usually higher when the loan is paid in installments, in the form of EMI.
The gradual reduction of the loan balance through regular interest and principal payments is called ‘amortization’. The bank uses an amortization calculator to determine the amount of monthly payment, so that each payment is the same amount.
Interest on saving account and other deposits in bank
Compound interest is paid on our deposits with the bank. Interest on such deposits is calculated using the same formula (as of simple interest), but it is done according to a “compounding” schedule, which can be daily, monthly, quarterly or annually. Compounding refers to the frequency with which the bank calculates the interest on the deposits. The interest is then added to the balance. A simple example- if you deposit Rs. 1000 with the bank at 10 % interest rate maturing after 3 years, after one year it becomes Rs. 1100. Another Rs. 100 as interest will be added in the second year, and yet another in the third year. So the amount you will receive on maturity will be a bigger amount- Rs. 1300.
Factors affecting Interest rate
Interest rate depends on the activities and fluctuations in the money market. It depends on the demand and supply of money in the economy at a given time. The three main economic factors that affect interest rates are-
- Policies of the Central bank- The apex bank or the central bank of the country (RBI in India) is responsible for monetary stability in the country. To achieve this objective an important function of the Central bank is credit control. The apex bank controls the money supply in the economy through measures like changing the Cash Reserve Ratio and the Repo Rate and Reverse repo Rate. The repo rate in common terms, is the interest rate at which the commercial banks borrow from the RBI. When there is inflation and the central bank wants to curb money supply and credit creation in the economy to check inflation, it will raise the interest rate and CRR, thus making borrowing costly. The commercial banks in turn pass on this increased rate to it’s customers. The reverse happens during recession. To boost the economy, interest rate is lowered by the Central bank, thus making credit cheaper for investment.
- Recession- During recession economic activities slow down. Expectation of fall in profit margins discourages investment, reducing the demand for credit. This results in fall in interest rate.
- Inflation- Inflationary pressures tend to raise the market interest rates. This is because, when prices are expected to rise considerably, the lender will be reluctant to lend during that period, fearing a loss of purchasing power of the loaned amount, on maturity. To compensate this loss, a higher interest rate is charged.
- State of the economy- When the economy is growing, the demand is also growing with increased expectation of profit in the future. Hence there is more demand for credit for investment purpose, which raises the interest rate. The opposite happens during recession.
Some other factors that affect the interest rate are
- Credit and payment history- Any default in payment of loan amount will adversely affect your loan amount and raise the interest rate.
- Debt to income ratio- Monthly debt obligation and income get converted to a debt-to-income ratio when we apply for a loan. Often, the higher the ratio, the higher is the rate offered.
- Loan amount and property value- This is known as LTV or loan-to-value. More equity decreases the risks involved with lending. Hence a lower LTV may result in a low interest rate.
- Property type- The size of property, number of persons involved, whether for personal or commercial purpose, such factors affect the rate of interest.
- Loan amount- Higher loan amount may result in discounted interest rate, just like the case of bulk buying.