Interest Rate: Definition, How It Works, Examples

Interest is the cost of borrowing money. When borrowing money from a lender, you must pay them an interest rate on top of your principal amount. That means interest is the profit a lender makes by lending you the money.

If you are a credit user, you must have noticed that each credit product comes with a different interest rate. For instance, a car loan is 7.5%, a Home Loan is 10%, and a Personal Loan has a 15% rate of interest. It may also vary from borrower to borrower, lender to lender, and loan scheme to loan scheme. Moreover, it may leave you wondering what's happening and why they are so different. Understanding what interest rates are will let you take control of your finances and become a smart borrower. Read on to learn exactly how interest rates work.

What is an Interest Rate?

Interest rate is the percentage of the borrowed amount you pay the lender when borrowing their money. You must pay it over and above the original amount you borrowed from them. Similarly, if you deposit your money in a bank or financial institution, they pay you interest for using your cash. 

When you borrow money at a high interest rate, the loan will be expensive, and you will end up paying a hefty amount above the borrowed amount. On the other hand, when the interest rate is low, the loan cost decreases, and borrowing becomes easier.

How Interest Rates Work When Borrowing?

When borrowing money, you must pay the principal amount back to the lender along with the charged interest amount. Typically, it is the annual percentage of the principal amount the lender charges for the loan. You may obtain credit in various forms, including Personal Loans, mortgage loans, car loans, Home Loans, credit cards, etc.

For instance, if you borrow ₹1 Lakh from a lending institution at a 10% interest rate per annum for five years, you will end up paying ₹ 1.5 Lakh by the term end. The lender will distribute your repayment in monthly installments of ₹2500.

Also Read: Penal Interest: Meaning, Definition & How It Is Calculated

Types of Interest Rates

Now that you know what is interest, it's time to learn about its types. Here's an overview:

Simple Interest Rates

Compound Interest Rates

Fixed Interest Rate

Variable or Floating Interest Rate

Also Read: What Is The Difference Between Fixed And Variable Loan Interest Rate?

APR vs. APY

APR, the Annual Percentage Rate, is the interest rate lenders demand from their borrowers. APY is the Annual Percentage Yield, the interest you earn from bank cash deposits. While both APR and APY measure interest, the major difference is that APR goes out, and APY comes in. APR uses a simple interest calculation method, while APY uses a compounding interest calculation method.

A lower APR rate is usually better since APR represents the amount you must pay for a loan. On the other hand, APY represents the interest amount you earn each year. Therefore, looking for a higher APY rate is more beneficial.

Also Read: Reverse Repo Rate: Meaning and How It Works?

How do Lenders Determine Interest Rates

Lending entities determine interest rates based on various factors, including your DTI and credit ratios. The idea is to evaluate the risk involved in lending money to you. Your interest rate also depends on the loan type, as it may vary for Home Loans, Personal Loans, and auto loans. 

For instance, if you seek a loan of ₹5 Lakh, the lender will determine the loan's cost. Apart from the expenses involved, the lender also wants to make some profit through the interest rate you pay. If they charge a 10% Personal Loan interest rate, you must pay 10% of 5 Lakh, i.e. ₹ 50,000. That means you must pay a total of ₹ 5,50,000 to borrow the loan from them.

Also Read: Reducing Vs Flat Interest Rate: Know The Difference

Factors Affecting Interest Rates

Lending institutions consider several factors in determining your loan interest rate, including the following:

Inflation Rates

When inflation rates rise, lending companies increase their interest rates to reduce the loan demand and curb inflation. 

Market Demand and Supply

The higher the market demand and supply of loans, the higher the interest rates will be. As a result, the demand for loans decreases, and the economy comes back on track.

Government Debt

If the lending institution must pay a higher repo rate to the RBI to borrow finance, they will charge you a higher interest rate to compensate for their loss. Therefore, the government debt interest rate largely affects your interest rate.

Economic Conditions

Economic conditions, geopolitical environment, and other factors impact the lending industry, influencing the interest the lenders charge from borrowers.

Credit Scores

Your credit score also determines the loan interest rate. A higher credit score indicates responsible credit behaviour, making lenders feel safe lending to you at a lower rate.

Conclusion

After understanding the interest rate meaning, you must have realised that interest is fundamental to loans. It considerably impacts your financial decisions, including borrowing, investing, and saving. Understanding what interest rates are, their types, and working will help you make informed decisions about borrowing and saving.

Also Read: What Factors Are Considered To Calculate The Interest Rate?

Frequently Asked Questions

1. What is the prime rate?

The prime rate is the interest rate lenders offer to their best account holders like large corporations.

2. Can I negotiate interest rates on loans?

Those with a good credit rating can negotiate loan interest rates based on their repayment history, DTI ratio, and credit history.

3. How do you define interest rates?

Interest rate is a percentage of the principal amount that a borrower pays the lender for borrowing and using their money.

4. What is the rate of interest in simple words?

In simple words, the interest rate is the percentage of the principal amount the lenders charge for providing their money and services.

5. Why is it called the interest rate?

It is called the interest rate because lenders calculate it as a percentage of the principal amount. Even if you borrow a big loan size, the rate might remain the same, but the interest outgo may increase.

Disclaimer: Please note that the interest rate mentioned is subject to change based on various factors and individual circumstances. The final interest rate offered may vary after considering additional elements, such as credit score, loan duration, and market conditions at the time of application.