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Interest rate (IR)

Interest rate (IR)

Interest rate is the rate in terms of percentage a borrower is charged on the borrowed principal amount by the lender. This percentage is calculated against the principal amount outstanding amount to arrive the interest payment a borrower is supposed to make to the lender.

The lender when lends the money to the borrower, the interest rate is charged to the borrower for using lender’s money. In case of loan taken from banks, interest is paid to the bank by borrower where as for the deposits made with the bank, the bank will pay the depositor interest on the deposit amount. Banks usually charge more for the borrower as compared to the interest rate is pays to the depositor. This is the operating profit margin for the banks to play and run the business with.


How to calculate interest rate and example of interest rate?

Consider the example where the principal loan amount is 1 million. Let’s say the agreed interest rate here is 12% by both the borrowing and lending party. Then the interest amount will be = Interest rate*principal amount= 1000000*.12=120000

Principal amount Interest rate Interest amount

1000000 12% 120000


Difference between interest rate and APR.

Interest rate is the percentage charged on principal amount as agreed by both the parties. The APR is the annual percentage rate which is calculated using the interest rate on the loan and including the charges of handling the loan. Charges such as broker fees, underwriting cost and discount rate are considered while arriving at APR

How interest rate works, its importance and effect on economy?

Interest rate is the charge a lender charges the borrower for using his money. Depending on both the parties, interest rate will vary as there are plenty are players to play on both the sides. Banks will usually charge less if the borrowing party has a good reputation in paying back loans. On same note, it will charge a relatively higher interest to the party where the risk of repayment of borrowed money is involved. Different banks will offer different interest rate for the same party. Interest rate will have differ with the amount borrowed loan amount.

In a country usually the base or prime interest rate is controlled by the central bank to control the inflow and outflow of money in the market. If the outflow is more, the flow can be brought down by bringing down the interest rate and vice versa.

Types of interest rates

There are different types of interest rate depending on the scenario a loan is being provided. Below is their explanation,

1. Fixed Interest:  As the name indicates, in this type the interest is fixed throughout the tenure of the loan. The rate doesn’t change and the borrower will have to make the same interest payment along with the principal amount till the loan completes its duration. In case of single repayment schedule, the fixed rate is calculated on principal amount borrowed and the borrower will payback principal along with interest amount to the lender. This is the easiest form of interest rate to calculate and most widely used.

2. Variable interest: In this type the loan interest rate is pegged to a base rate. As the base rate fluctuates in the market, the variable interest rate linked to it will also change. The borrower can benefit from this type of interest rate when the base rate decreases, the interest payment according to the new decreased interest rate will also decrease. These type of interest rate carries a risk for both the parties as the borrower will lose if the base increase and the lender will loses if the base rate decrease.

3. Annual Percentage rate: This interest rate is the total interest on the principal amount outstanding expresses annually. APR is used in case of tenured loans and credit card interests. It is arrived at by adding the prime base rate and the margin rate the lender is keeping for a particular loan amount.

4. The Prime Rate: This interest rate is the rate usually a bank defines for its reputed customers and is pegged to the country’s central bank interest rate (Repo rate in case if India). Most of the loans given out are arrived by pegging the same to the prime rate.

5. The discount rate: This is the interest rate charged by US federal bank to the financial institution as a lender (Repo rate in case of India where RBI is the central bank). Banks will borrow money from federal bank in case of liquidity crisis at this rate.

6. Amortisation rates. The interest rate agreed by both parties while offering the housing or vehicle loans which have fixed tenure is known as amortisation rate. The lender which is usually bank will prepare the amortisation loan schedule to calculate equated monthly instalment using amortisation rate.

7. Simple interest: This is the usual interest where the interest is calculated on the principal amount and requested for payment by the borrower for that tenure.

8. Compound interest: In this type of interest the interest amount charged by lender at the completion of first year if not paid is simply added to the principal to arrive at new outstanding amount principal.

Example of compound interest : IF the principal amount in $1000 and the compound interest is 10%, at the end of first year the interest owed will be $100, this if not paid is added to the principal in the second year. Then the total interest owed for second year will be 10% on $1100 which is $110.


Advantages of interest rate

• Borrower can benefit from fixed interest rate as they can realise how much actual payment they need to make for the particular loan.

• Economy’s money flow can be controlled by controlling the base rate of the country.

• Lender bread and meal is earned by the interest rate as the source.

• Borrower can meet is cash crisis by borrowing money and paying interest.


Disadvantages of interest rate

• Variable interest rate can cost the borrower and lender both the money depending on the fluctuation of the pegged base rate.

• Price of the goods fluctuate can shoot up if the associated interest rate for the business owner raise.

• Competitiveness of interest rate can give the same party two different interest rate from the same market and for same loan amount.


Conclusion

Interest rate is the percentage on the principal charged by the lender to the borrower for using his money for that particular tenure. It is one of the crucial parameter in maintaining and controlling the economy. The development of an economy or any particular sector can be pushed backwards or forwards by managing the interest rate. Money outflow/inflow can be controlled by controlling the interest rate. For the same reasons, any country’s interest rate is defined and controlled by its central bank. Banks charge a premium on these base rate to the loans provided to make living. This premium again depends on the borrower, lender, loan amount and purpose.




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