You're watching the news and
they're talking about a recent
announcement from RBI, in which
it is hinted that the interest rates
may be raised in the next week.
The stock market drops the next
day. Why?
How Do Interest Rates Work?
– By Prof. Simply Simple TM
Before you get all worked up, you
should know that interest rates
aren't evil.
They're the price of living in a world
that relies heavily on credit and
debt.
If interest rates didn't exist, lenders
would have no reason to let you
borrow money.
And if you couldn't borrow money,
you could never buy a house or a
car, or enjoy many of the other
advantages of life with credit, like
buying air tickets and paying bills
online with a credit card.
So if interest rates are so
important, how do they work?
In this lesson, I'll help you
understand why interest rates
exist, how they're calculated
and why they change over time.
An interest rate is the cost of
borrowing money.
A borrower pays interest for the
ability to spend money now,
rather than wait until he's
saved the same amount.
For example, if you borrow `100
at an annual interest rate of five
percent, at the end of the year
you'll owe `105.
But interest rates aren't just
random punishments for
borrowing money. The interest a
lender receives is his
compensation for taking a risk.
How?
With every loan, there's a risk that
the borrower won't be able to pay it
back.
The higher the risk that the borrower
will default (or fail to repay the loan),
the higher the interest rate.
That's why maintaining a good credit
score will help lower the interest rates
offered to you by lenders.
The nice thing is that interest rates
work both ways.
Banks, governments and other large
financial institutions need cash too,
and they're willing to pay for it.
If you put money into a savings
account at a bank, the bank will pay
you interest for the temporary use of
that money.
Governments sell bonds and other
securities for the same reason.
In this case, you're the lender to the
government and the interest rate is
your compensation for temporarily
giving up the ability to spend your cash.
But remember, savings accounts and
government-issued bonds pay relatively
low interest rates because the risk of
their defaulting is close to zero.
You should also know that interest rates
for unsecured credit will always be
higher than secured credit.
Secured credit is backed by collateral. A
home loan is a classic example of
secured credit, because if the
borrower defaults on the loan, the
bank can always take the house.
Credit cards are unsecured credit,
because there's no collateral backing
the loan, only the cardholder's credit
score.
Long-term loans also carry
higher interest rates than short-
term loans, because the more
time a borrower has to pay
back a loan, the more time
there is for things to possibly go
bad financially, causing the
borrower to default.
Another factor that makes long-term
loans less attractive to lenders -- and
therefore raises long-term interest
rates -- is inflation.
In a healthy economy, inflation almost
always rises, meaning the same
rupee amount today is worth less five
years from now.
Lenders know that the longer it takes
the borrower to pay back a loan, the
less that money is going to be worth.
That's why interest rates are
actually calculated as two different
values: the nominal rate and the
real rate.
The nominal rate is the interest
rate set by the lending institution.
The real rate is the nominal rate
minus the rate of inflation.
For example, if you take out a
home loan with a nominal
interest rate of 10 percent, but
the annual rate of inflation is
four percent, then the bank is
only really collecting six
percent on the loan.
So how do interest rates affect
the rise and fall of inflation?
Well, lower interest rates put more
borrowing power in the hands
of consumers. And when
consumers spend more, the
economy grows, naturally
creating inflation.
If the RBI decides that the economy
is growing too fast-that demand will
greatly outpace supply-then it can
raise interest rates, slowing the
amount of cash entering the
economy.
So there must be enough economic
growth to keep wages up and
unemployment low, but not too
much growth that it leads to
dangerously high inflation.
Hope you have now got an
understanding of how
interest rates work at a
conceptual level.
Do write to me at
professor@[Link]
Disclaimer
The views expressed in these lessons are for information purposes
only and do not construe to be of any investment, legal or
taxation advice. The lessons do not cover the depth of the
subject.
The contents are topical in nature & held true at the time of
creation of the lesson. They are not indicative of future market
trends, nor is Tata Asset Management Ltd. attempting to
predict the same. Reprinting any part of this presentation will
be at your own risk and Tata Asset Management Ltd. will not be
liable for the consequences of any such action.