What is interest ?

Having got an introduction about investing and inflation, the next important financial concept you need to know is interest.

  • Interest, usually expressed in terms of a percentage, is the additional amount you pay for using borrowed money or the return you get when you invest it with an institution like a bank.
  • It’s also the compensation you can demand if someone delays a payment that’s due to you. So interest is an expense when you pay and it’s an income when you receive it.

Knowledge about interest is vital in making correct financial decisions. For example, your friend borrows 2 lakhs from you for 6 months and returns it promptly. Is there any loss for you? The answer is- Yes. Your 2 lakhs would have appreciated in value if you were to put it in a bank. Assuming that the bank pays 10% per annum interest for money deposited with them, you lost the opportunity to earn Rs 10,000. That’s the loss.

The point we like to stress here is that, for any delay in receipt of money, you lose the opportunity to earn risk free interest. So, quantifying opportunity loss, which is vital to making investing decisions, is done with the help of the concept of interest.

Interest rate also helps you compare investment alternatives – for example you are faced with a decision to buy a piece of land for 10 lakhs which has the potential to appreciate to 15 lakhs in 5 years time. Should you buy it? Would it be a good idea? May be not. Because, the same 10 lakhs, if you were to deposit in a bank fixed deposit that pays 10% would have returned 16.10 lakhs at the end of 5 years.

So, in any financial transaction where a delay in receipt of money is expected, interest rates come into play. It would help you take correct financial decisions.

The relation between interest rates and inflation.

People borrow more when the interest rates are low. When people get more money at their disposal, the demand for goods tend to rise and the economy starts to grow rapidly. Naturally, as the demand increases, the prices of goods would go up and this leads to inflationary conditions. So, the solution from the government’s part to curb inflation is to increase the interest rates and restrict the flow of money into the economy. When the interest rates are increased, the credit growth decreases or people borrow less and hence, would have less money to spend. When the consumers spend less, the demand for goods decreases and the economy starts to slow down and as a result, inflation decreases.

Hence, interest rates are closely linked to the inflation in the economy.

 Types of interest rates.

There are different types of interest rates prevailing in an economy. There are repo interest rates and reverse repo interest rates which are reserve bank’s lending and borrowing rates and there are interest rates like compound rates and floating rates which are terms used by commercial banks or investors to calculate interest.

The repo rate and reverse repo rates are used for the purposes of controlling inflation as said above. The repo rate is the rate at which the reserve bank allows the local banks to borrow money from it whenever there is a shortage of funds. If the repo rates are low, commercial banks get funds from the reserve bank at cheaper interest rates and can lend it to their customers at lower rates. The end beneficiary of lower repo rates is the commercial banks and the customers like you and me.

The reverse repo rate the opposite of repo rates. This is the rate at which the reserve bank would take funds from the commercial banks. When the reverse repo rates are high, the commercial banks would be happy to give money to the reserve bank as that they can get risk free income.

Coming down to the rate to be applied for taking financial decisions, there are three types of interest rates – simple interest, compound interest and diminishing interest rates.

Simple interest, as the name says, is the simplest way to calculate interest. For example the simple interest for Rs 100,000 at 10 % per annum would be Rs 10,000.

Compound interest is a bit more complicated to calculate than simple interest. Here the assumption is that interest generated further generates interest. For example the compound interest for Rs 100,000 at 10 % per annum, compounded half yearly would be Rs 110,250. That is, 10% of Rs 100,000 is calculated at the end of 6 months and that interest is added to the principal amount for the next 6 months. The calculation is shown below:

Invested amount = 100,000.

Rate of interest = 10% per annum.

Interest for the first 6 months = 5000

Total amount at the end of 6 months = 100,000 + 5000 = 105,000.

Interest for the next 6 months = 105,000 x 10% = 5250

Total interest earned = 5000 + 5250 = 10,250.

The above calculation may not seem to be a complicated calculation for you. That’s because, the frequency of compounding was restricted to 6 months. As the frequency factor increases, compounding becomes more and more complicated to calculate. For comparing investment alternatives or opportunity loss, you can use simple interest or compound interest.

Diminishing interest rates are typically applied by banks when they lend money to you. Under the diminishing interest rate method, the bank would fix a monthly installment that would have an interest component and a principal component. After you pay the first month installment, the interest for the second month is calculated after deducting the principal paid for the first month.

If you bank has given you a loan on floating interest rate, it means that the interest rate e can keep changing with the changes in the repo rates. The implication is that your repayment amount will keep fluctuating as the interest rates keep changing. The opposite of this is called fixed interest rate, where the bank will not keep changing the interest rate whenever there is a change in the basic interest rates of the economy. So if you avail a loan for a fixed rate of interest, you can calculate the future money outflow accurately. Applying the same principle, a deposit accepted by the bank by committing a fixed interest rate is hence, called a fixed deposit.

A flat interest rate would mean that interest will be charged for the entire amount irrespective of the amount paid. For example – if you have borrowed Rs 100,000 at 10% flat interest rate for 5 years, it means that the interest for all the 5 years would remain the same – Rs 10,000. So, effectively first year you will pay Rs 10,000 or 833.33 per month as interest. Even if you pay Rs 20,000 towards principal for the year, the interest charged for the second year will be constant at Rs 10,000.

Example 1- You are offered a loan for Rs.2 lakhs and your EMI works out to say, Rs. 18000 with 2 EMI’s payable in advance. Effectively, you are getting only Rs 164,000 in hand. But since the interest rate is calculated as if the entire 2 lakhs is given to you, the rate of interest you pay is actually very high. Is that all? No. The bank will also deduct a processing fee of 1 % of the ‘total amount’ ie. Rs 2000 for a 2 lakhs loan. So on net, you get Rs 162,000.

 Example 2. You are offered the same loan for reducing balance interest. You feel light thinking of the fact that interest is charged only on the balance outstanding. But if you look closer at the terms and conditions you may find that  – reducing balance can be on monthly basis, half yearly basis or on Annual basis. If it’s on annual basis – your interest is calculated on the amount outstanding at the ‘beginning’ of the year. So, you keep paying interest on a higher amount even though your loan is decreasing every month. This pushes up the effective rate of interest you pay. So, that’s another trap.  Always confirm whether the reducing balance is on annual basis or half yearly basis.

 The best way to deal with these interest  traps is to stop comparing the interest rates and instead, compare the EMI’s and compute the total amount going out of your pocket including processing fee and pre-closure charges. This will give you the right picture of which loan is actually right for you.

Interest income

 In the case of interest incomethe principle to be learned is quite simple – The earlier you get it, the better it is.

This principle will help you to compare different offers. For example – A bank offers 8% P.a  interest on FD , payable annually. NSC also offers 8% P.a but, payable half yearly. You get another offer on FD which pays interest at 8% p.a – payable monthly. Which is better? The one you get on monthly basis, of course!. Why? Because, the bank’s effective rate is 8% , the NSC’s effective rate is 8.16% and the third option of FD gives you an effective annual interest rate of 8.30% !

How? Let’s calculate with an example –

  • Let’s assume that you have 2 lakhs with you.
  • The bank would give you 8% – annually so, you receive an interest income of Rs.16,000 at the end of one year.
  • Suppose you deposited the same with NSC They would give you  8% -half yearly. So, at the end of 6 months you get Rs 8,000 which can be again invested for 8% interest for 6 months which gives you an additional interest of Rs. 340. So, the total interest you receive is now Rs 16,340. effective rate – 8.16%
  • Similarly , when you work out 8% interest received on a monthly basis the effective interest rate would work out to 8.30%

That’s the concept of interest and some of the practical scenarios where it’s applied. Interest rates and its effect, impacts the financial decisions you make.

1 comments On What is interest ?

  • Hi, Jins!

    The Concept of ‘Diminishing interest rate’ was new to me. Also, I have difficulties in calculating the maturity amount in case of compound interest compounded quarterly. Can you share the formula with an example for the same?

    I prefer staying away from bank loans as the bank charges very high interest and their whole process of lending money to their customers is dishonest. I would like to know your thoughts on it. If you had to take a loan which method would you prefer?

    These days banks are giving the lowest interest rates around 7% pa. I prefer to invest my money in liquid funds like short term gilt funds which are very safe and backed by the government. They easily give me interest above 10% pa.

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