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Important Factors Affecting Interest Rates

Important Factors Affecting Interest Rates

Anyone in the financial industry already knows how rapidly the interest rates on savings and loans keep changing. It might be because of various parameters such as monetary policies by the RBI, inflation, economic development, etc. However, regardless of the reason behind interest rate fluctuations, there are certain things you must understand. This post helps you evaluate the basics of interest rates, how interest rates work, and important factors affecting interest rates of personal loans.

An Introduction to Interest Rates – Understanding the Meaning

Interest rates are the “cost of money.” Simply put, it’s an amount a financial bank/lender/financial institute charges the borrower. It is calculated in percentages depending on the principal or the number of loans. An interest rate on a loan comes annually and is denoted as APR or annual percentage rate.

For borrowers, it’s compensation for using the money lent. Banks and financial institutes also pay an interest rate as a percentage to people who save money in their accounts. It’s a type of reward given by banks or financial institutes. The best example of such a reward is the fixed deposit, or FD.

How Does Interest Rate Movement Work?


When you borrow an amount of money, there are some reasons behind your decision. Say, for instance, that you want to start a business or buy your dream home. In such circumstances, when you visit the bank or financial institute for a loan, your lender will charge a certain interest rate.

The lender calculates the rate of interest using either of these methods – compound interest or simple interest. Compound interest is based on the principal amount. It’s the accumulated interest of past periods and is called “interest on interest.”

Lenders have to pay higher interest rates when the lender follows the compound interest method. The interest here tends to be higher than the simple interest method. The interest gets charged on the principal monthly, including the accrued interest from past months. The method to calculate compound interest is as follows:

Compound interest = p x [(1 + interest rate) n − 1]

Here, p is the principal, while n is the total number of compounding periods.

On the other hand, simple interest is calculated on the loan's original amount, i.e., the principal amount.

Suppose you apply for a Rs. 50,000 loan from a lending institute or bank. The loan agreement includes 3% simple interest. So, the interest rate is Rs. 1500. The bank or financial institute calculates the simple interest as:

Simple interest = principal x rate of interest x time

That’s how the interest rate for loans works.

The rate of interest determines the amount of money you receive during the life of your loan. The institute or bank charges higher rates if the risk of default is higher. Suppose you have bad credit and you wish to apply for a loan.

In such circumstances, the lender views your risks differently and charges a higher interest rate. Interest rates may vary based on the loan type. Mortgages may use simple interest, while some loans opt for compound interest.

Now, let’s come to the discussion of saving money and getting a percentage as a reward.

Most people prefer saving money in financial institutions or banks. When you save a certain amount of money in a bank or financial institute, you allow them to use your money. So, as a depositor, you receive a certain amount of money at an interest rate as compensation.

The bank rewards you with this amount because you allow it to use your money to fund investments and loans. The rate gets charged based on the total amount of money they save. Let’s find out the important factors affecting interest rates:

Factors Affecting Interest Rates in India

The concept of interest rates is a huge topic of discussion in finance. If you wish to learn about parameters that affect interest rates in India, the following points are categorized based on two types: First, let’s discuss the factors that affect interest rates on loans. Then, you can discover the parameters that affect interest rates in general.

Parameters Impacting the Interest Rates on Loans

What are the four factors determining interest rates on loans? Let’s evaluate them one by one:

Defaults

NBFCs and banks hesitate to approve loan applications of defaulters. The best they can do is approve the loan at a higher interest rate. Now, who is a defaulter? In simple language, a defaulter is someone who’s not consistent with their repayment abilities and time.

Failing to repay debts can result in defaults. So, if you have been in default on your CIBIL report for more than five consecutive years, you may have fewer chances to get your loan application approved or may be charged a higher rate of interest.

Your Loan Term

The loan term is the length of your loan and is one of the determinants of interest rate fluctuation. The term may also influence the rate of interest. Usually, banks and financial institutes offer higher interest rates to an eligible candidate who opts for a longer loan period.

Your Salary or Income

Suppose you want to apply for a personal loan. In such cases, your income might be a prioritised parameter that the lending institute determines. Financial institutions evaluate your employment stability and income.

They determine the repayment capacity by assessing your income details. You may get a better interest rate with a stable monthly income. A consistent job history may also increase the interest rates.

Your CIBIL Score

Your CIBIL score may range between 300 and 900. The higher the amount, the more seamless it is to get better interest rates. Usually, a candidate with a 740 or higher credit score is eligible to get the best interest rates from the lending institute or bank. You can improve your credit score by frequently checking it and discovering ways to improve it.

Parameters Impacting Interest Rates in General

The following are the factors that affect interest rates in general:

RBI Policies

Government policies have an influential impact on the changing rate of interest. When the central government wishes to make money, it lowers the interest rate. In general, the Reserve Bank of India uses reverse repo rates and other rates to improve lending and borrowing rates in India. The changes may have a ripple effect, affecting other rates of interest like credit card rates, mortgages, and more.

Stock Market Conditions

Corporations fulfill their funding needs by borrowing from lending institutes or choosing funds from stocks. Suppose the markets are bullish. In such cases, companies might prefer to choose equity expansion.

Nonetheless, these corporations prefer to borrow from financial institutes during any poor market cycle. The increase in borrowing demand affects the interest rate.

Macroeconomic Parameters

Macroeconomic situations may impact interest rates. Some of the factors that affect interest rates based on macroeconomic scenarios include the following:

Demand and Supply

Lenders would automatically increase interest rates with higher credit demand. That offers more opportunities for lenders to make higher returns. Similarly, when there’s a decrease in borrowing habits, lenders reduce the rates.

Fiscal Deficits

A fiscal deficit occurs if the government spends more money than the amount collected from revenues and taxes. The government manages this deficit by borrowing from the market. The rate of interest will rise if the government borrows money to pay budget deficits.

Inflation and Deflation

Inflation is the increase in prices or the cost of living in an economy. So, there would be higher interest rates due to the rise in prices of goods and demand. On the contrary, deflation reduces interest rates since the demand for money falls.

Wrapping up

So, this post has compiled everything about interest rates in India. You now understand the meaning of interest rates and how it works in India. You have also read about the most important factors that affect interest rates in India.

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