What is Interest Rate?

When we take a loan, we have a lot of questions about what the rate of interest and term of the loan is. Even while making investment decisions, we often look at the interest rate of return, to ensure we park our funds in what we feel is the most profitable investment tool. The interest rate is a commonly used term, but often we do not fully know what it actually means and implies.  Given that interest rates often influence our expenses, savings, and financial decisions, let us find out more about it.

What is Interest Rate?

An interest rate is the percentage of the principal that a lender charges, for lending money or any other asset. The interest rate is not constant but varies based on macroeconomic factors like economic health of the sector, cash liquidity affecting RBI policy, inflation etc.

When you go for a loan, the lender generally assesses your credit worthiness. The lower the chances of you repaying the loan, the higher the interest rate. This is because the lender is taking a higher risk, and hence needs to be compensated more heavily.

Types of Interest Rate

Interest rates vary by type, and the general public is often ignorant of these types. Lending institutions often take advantage of this ignorance.

• Nominal Interest Rate: This is the simplest type of interest rate. It indicates the actual monetary price that borrowers pay to lenders to use their money or assets. It does not take into account the effect of inflation, any additional fees or of compounding. Lenders often advertise this rate for their products so as to make them appear attractive.
• Real Interest Rate: This provides a more realistic picture of interest payable because it factors in inflation. Inflation is unfavourable for borrowers as it reduces the purchasing power and hence reduces the ability to repay the loan taken. For example, if a bond compounds annually at a 6% nominal rate, and the inflation is 4%, the real interest is only 2%. Thus,

Nominal interest rate – Inflation = Real interest rate

• Effective Interest Rate: This takes into account the power of compounding. For example, a bond compounds semi-annually at a 6% nominal rate. If you invest Rs. 1000 in this bond, you will receive interest in two instalments due to the semi-annual compounding frequency. For the first six months, you will receive interest of (1000*0.03) i.e. Rs. 30. For the next six months, compounding will lead to an interest of (1030*0.03) i.e. Rs. 30.9. The total interest you receive is Rs. 60.90 making the effective interest rate equal to 6.09%. This is different from the earlier mentioned nominal rate of 6% because compounding was factored in.

Applications of Interest Rate

Knowing interest rates by type can help you make better investment decisions and grow your money significantly. Make sure you look out for the real interest rate so as to make investments that beat inflation. It is important to know the “true cost of borrowing” to be able to make cash-positive investments. Also, as a rule, higher the compounding frequency the more expensive the loan. Make sure to look out for both the real and effective interest rate when availing a loan.  It is also important to know the concept of simple and compound interest.

• Simple Interest: Interest is calculated only on the initial principal amount.
• Compound Interest: Interest is calculated on the initial principal and also on the accumulated interest of previous periods i.e. it provides interest on interest.

As a general rule, if you are an investor, compound interest helps you grow money exponentially. If you are a borrower, it means you pay up subsequently higher EMIs, hence stick to a lower compound interest, or preferably a simple interest loan.

Interest rates are a complex entity that govern financial decisions from an individual consumer level up to the high-level governance and policy-making processes. They create a lasting impact on your wealth and can push you towards financial sustenance or financial crises. So, the next time you are making decisions about investments or loans, don’t forget to pay special attention to interest rates.