What is Interest Rates: Meaning, Types & How to Calculate

The cost of borrowing money interest. When a bank makes a loan, interest on the principal loan amount is how the bank makes money.

Interest rates influence how much you pay for homes, cars, and other credit-based purchases. The method used to determine an interest rate depends on the type of loan.

To learn more about what is interest rates and how is interest rates calculated, read this article below.

How Do Interest Rates Work?

The amount that the bank charges the borrower over and beyond the principal amount is referred to as the interest rate. Considering the time value of money, anyone who puts money in a bank or similar financial institution also receives extra revenue in terms of the recipient, known as interest.

Types of Interest Rates 

Fixed Interest

The most prevalent type of interest rate commonly assessed to the loan borrower by lenders is a fixed interest rate. As the name implies, the interest rate is set for the loan's repayment period. When the loan is approved, it is often determined by mutual consent between the borrower and the lender. Calculations for this are more straightforward to understand.

Simple Interest 

Simple interest is charged to the principal or the amount borrowed originally. Since it is not compounded, interest is not added to the amount set to the loan.

As an illustration, if you borrow $100 at a five percent simple interest rate, you will pay $5 in interest over a year. Included are the $100 you borrowed plus the $5 interest.

Simple interest is frequently applied to short-term loans like personal, auto, and mortgages.

Compound Interest

A type of interest known as compound interest is charged on both the principal sum and any accumulated interest. In other words, the interest is charged once after being added to the principal.

Interest on interest is another name for the compound interest method. The calculation is typically in use by banks to calculate bank rates. It depends on two essential factors: the principal amount and the loan's interest rate. The interest will first be applied to the loan balance, and any outstanding balances will utilize the same sum to calculate the interest payment for the following year.

How Are Interest Rates Calculated?

Each compounding period requires that you pay at least the interest. The interest rate is determined by the bank using the total amount of your loan or credit card balance that is still due. If not, your overall debt will increase even if you are making a payment. Interest rates fluctuate while being fiercely competitive.

If a bank believes there is a decreased likelihood that the loan will be returned, it will impose higher interest rates. Rolling loans, like credit cards, frequently carry higher interest rates since managing them costs more money for banks. Additionally, banks charge riskier customers greater charges; hence, the better your credit score, the less of an interest rate you will be required to pay.

Factors Influencing Interest Rates

• Bank Rate: The Reserve Bank of India (RBI) loans money to commercial banks at a rate known as a "bank rate." No collateral is required for this lending, which has a longer term between about 90 days and one year. Banks earn money by offering consumers interest rates above those set by the RBI. Thus, interest rates increase when the RBI loans at a greater interest rate.

• Repo Rate: Also referred to as the repurchase rate, this is the rate at which commercial banks borrow funds from the RBI to fill the gap between consumer need for loans and the amount of cash they still have available to offer. It is a short-term loan granted to the banks in exchange for securities, with the understanding that they will quickly repurchase the securities. Repo rate aids the RBI in preserving market liquidity. By raising the repo rate, the RBI raises the cost of borrowing (interest) for the average person while making it more expensive for banks to borrow money. Thus, both are set by the RBI and impact interest rates.

• Demand and supply: The interest rate will rise as the demand for loans and credit increases, while the interest rate will decrease as the supply of credit increases. When customers open bank accounts, the amount of credit increases, and more money is available for lending. However, when borrowers hold off making the payments on their loans, less credit becomes available, which raises the interest rate.

• Inflation: Deflation and inflation have a big impact on interest rates. Interest rates increase due to inflation since money no longer has the same buying power. Additionally, when there is inflation, investors demand a higher interest rate for the same reason. The interest rates are elevated as a result.

• Loan Type: Lending money always carries the risk that it won't be repaid. The interest rate is usually higher for loans deemed "unsecured."

• Income growth: As general wage rates rise, interest rates also do. Interest rates fall if the RBI loosens its monetary constraints to promote market liquidity. But this can lead to inflation. However, tighter policies result in higher interest rates, which lower inflation. As a result, RBI must maintain a monetary system balance. The repo rate needs to be determined at this point by the RBI. And other interest rates are impacted by this repo rate.

• Economic boom: As the economy grows, so do the credit demand and the cost of borrowing.

• Uncertain economic future: Lenders protect themselves against the uncertain future by raising loan rates under unstable situations, such as elections, new governments, changing government policies, etc. In addition to these, because they are all interconnected, other factors like unemployment, inflationary pressures, unused capacity, exchange rates, real estate prices, etc., have a major impact on interest rates.

What Is Interest Rate On Savings Account?

Numerous public and private banks in India provide people with various savings accounts to suit their needs. Savings accounts are preferred by those with little or no experience in banking or investing because they offer a great way to put aside some money for either short- or long-term goals. Depending on the amount saved, all banks determine interest rates that typically range from 2.50% per year to 7.00%.

Bottom Line

Interest rates have an impact on your spending. Lending institutions cost more during periods of high-interest rates. Individuals and companies borrow less money and save more. Companies sell fewer goods as demand declines. Economy deteriorates. It can become a recession if it continues for too long. Therefore, understanding interest rates and everything related to them is crucial today.