Interest Rate: Meaning, Types, How to Calculate, Floating Interest & Importance

Interest Rate

Key Highlights

Interest rate refers to the percentage charged by a lender to a borrower for the use of money or the percentage earned on savings or investments over a specified period.
Types of interest rates are fixed, floating, simple and compound interest rates.

What is Interest Rate?

Interest Rate refers to the percentage charged by a lender to a borrower for the use of money or the percentage earned on savings or investments over a specified period. It is essentially the cost of borrowing money or the reward for saving or investing it.

Types of Interest Rates

1. Fixed Interest Rate: The rate remains constant throughout the loan or deposit tenure.

2. Floating Interest Rate: The rate fluctuates based on market conditions, typically linked to benchmarks like the Reserve Bank of India's (RBI) repo rate.

3. Simple Interest: Simple Interest: Determined solely based on the principal amount.

4. Compound Interest: Calculated on the principal amount and the accumulated interest from previous periods.

How to Calculate Interest Rate?

1. Simple Interest Formula:

Simple Interest= Principal×Rate×Time/100

For example, if you invest ₹10,000 at an interest rate of 8% for 2 years:

Interest= 10,000×8×2/100 = ₹1,600

2. Compound Interest Formula:

Compound Interest=Principal×(1+Rate/100)^Time − Principal

For instance, if you invest ₹10,000 at 8% for 2 years:

Amount=10,000×(1+8/100)^2 = ₹11,664

Compound Interest = ₹11,664 − ₹10,000 = ₹1,664

What is Floating Interest Rate?

A floating interest rate changes over time, depending on market conditions or changes in benchmark rates.

Example: A home loan with a floating interest rate might be set at "Repo Rate + 2%." If the RBI reduces the repo rate by 0.5%, the loan interest rate also decreases accordingly.
Pros: Offers savings when rates drop.
Cons: Can increase your financial burden if rates rise.

Factors Affecting Interest Rates

1. Monetary Policy: RBI’s decisions, such as changes in the repo rate.

2. Inflation: Increased inflation typically results in higher interest rates.

3. Demand and Supply: Increased demand for credit can raise interest rates.

4. Creditworthiness: Borrowers with a good credit score receive lower rates.

Importance of Interest Rates

For Borrowers: Determines the cost of loans, affecting affordability.
For Savers: Encourages saving by offering returns on deposits.
For the Economy: Influences spending, investment, and inflation.