Interest Rate: Summary Notes
1. Definition of Interest Rate
An interest rate is the cost of borrowing money or the return on investment for holding and
lending funds, expressed as a percentage of the principal amount over a specified period
(usually annually). It is typically quoted as an annual percentage rate (APR) or annual
percentage yield (APY).
Formula for Interest:
• Simple Interest (SI):
SI=P×R×T100SI = \frac{P \times R \times T}{100}
Where:
o PP = Principal amount
o RR = Rate of interest
o TT = Time period (in years)
• Compound Interest (CI):
A=P(1+rn)ntA = P \left( 1 + \frac{r}{n} \right)^{nt}
Where:
o AA = Amount after interest
o PP = Principal amount
o rr = Annual interest rate (decimal form)
o nn = Number of times the interest is compounded per year
o tt = Time period (in years)
2. Types of Interest Rates
1. Nominal Interest Rate (or stated rate):
a. The rate quoted by lenders or financial institutions.
b. Does not account for compounding during the year.
2. Effective Interest Rate (EIR):
a. The actual interest rate after accounting for compounding.
b. More accurate than the nominal rate for assessing the cost of borrowing or
the return on investment.
3. Real Interest Rate:
a. Adjusted for inflation to reflect the true cost of borrowing and the real return
on investment.
b. Formula: Real Interest Rate=Nominal Rate−Inflation Rate\text{Real Interest
Rate} = \text{Nominal Rate} - \text{Inflation Rate}
c. Important for investors and lenders to gauge the real value of money over
time.
4. Fixed vs. Variable Interest Rates:
a. Fixed Interest Rate: The interest rate remains constant throughout the loan
or investment term.
b. Variable (or Floating) Interest Rate: The interest rate changes periodically
based on market conditions or an index rate (e.g., LIBOR, RBI Repo Rate).
3. Factors Determining Interest Rates
Several factors influence the interest rates set by financial institutions:
1. Central Bank Rates:
a. The central bank (e.g., RBI, Federal Reserve) sets benchmark rates (such as
repo rate, discount rate) that influence the overall level of interest rates in
the economy.
b. Repo Rate: The rate at which commercial banks borrow from the central
bank.
c. Reverse Repo Rate: The rate at which commercial banks lend to the central
bank.
2. Inflation Rate:
a. Lenders want to maintain the purchasing power of the money they lend. If
inflation is high, interest rates tend to rise to compensate for the decreased
purchasing power.
3. Economic Conditions:
a. In a growing economy, demand for credit tends to increase, which can drive
up interest rates.
b. In periods of economic slowdown, central banks may lower rates to
encourage borrowing and investment.
4. Risk Factors:
a. Higher perceived risk (e.g., lending to a borrower with a low credit score)
results in higher interest rates to compensate for the risk of default.
5. Term of Loan/Investment:
a. Longer-term loans or investments generally have higher interest rates, as
there is more uncertainty and risk involved.
6. Supply and Demand for Money:
a. If there is an excess supply of money in the economy, interest rates tend to
fall.
b. If the demand for money is high (e.g., during business expansion), interest
rates tend to rise.
7. Government Policy:
a. Government policies such as fiscal policies, taxation, and monetary policies
can impact interest rates. For instance, if the government increases its
borrowing, this may increase interest rates due to a higher demand for funds.
4. The Role of Interest Rates in the Economy
• Borrowing Costs: Higher interest rates increase the cost of borrowing, which can
reduce consumption and investment.
• Investment Decisions: Lower interest rates make borrowing cheaper, encouraging
investment in business and infrastructure.
• Savings Incentives: Higher interest rates incentivize savings by offering better
returns, leading to increased savings in the economy.
• Monetary Policy Tool: Central banks use interest rates to control inflation and
stabilize the economy. By raising rates, they can control inflation; by lowering rates,
they can stimulate economic activity.
5. Interest Rate and Its Impact on Financial Products
Interest rates directly impact various financial products, such as loans, deposits, and
bonds:
1. Loans:
a. Personal Loans, Car Loans, Home Loans: The interest rate affects the total
cost of the loan. Fixed rates provide predictability, while variable rates can
lead to fluctuations in repayment amounts.
2. Savings Accounts:
a. Deposits and Savings Accounts: The interest rate offered by banks on
savings accounts determines the return on deposits. Higher rates incentivize
people to save more.
3. Bonds:
a. Bonds with Fixed Interest: Higher interest rates make newly issued bonds
more attractive, lowering the value of existing bonds with lower rates.
Conversely, when interest rates fall, the value of existing bonds rises.
4. Credit Cards:
a. Interest rates on credit cards are typically higher due to the unsecured
nature of the loan.
6. Real-World Examples
• Mortgage Loans: In countries like the U.S. or India, the interest rate on home loans
is typically influenced by central bank policies. If the Federal Reserve (U.S.) or the
Reserve Bank of India raises rates, mortgage rates tend to rise as well, increasing
monthly repayments.
• Government Bonds: Governments issue bonds at fixed or floating interest rates.
When interest rates in the economy increase, the yield on government bonds also
rises, making them more attractive to investors.
7. Interest Rates and Inflation
The relationship between interest rates and inflation is crucial for economic stability:
• Inflation: As inflation rises, the real value of money decreases. Central banks may
raise interest rates to control inflation, as higher rates make borrowing more
expensive and reduce demand, helping to stabilize prices.
• Deflation: In periods of deflation (falling prices), central banks may lower interest
rates to stimulate borrowing and investment.
8. Conclusion
Interest rates are a fundamental economic variable that affects the cost of borrowing, the
return on investment, and overall economic activity. They are influenced by a variety of
factors, including central bank policies, inflation, risk, and market conditions.
Understanding interest rates is essential for making informed financial decisions, whether
for saving, investing, or borrowing.
These summary notes provide an overview of interest rates, their types, factors that
influence them, and their role in the economy. It covers everything from the basic formulae
to real-world applications, helping you grasp the importance and impact of interest rates in
economic activities.
