Fundamentals of Interest Rates

Definition of 'Interest Rate'
The amount charged, expressed as a

percentage of principal, by a lender to a
borrower for the use of assets .
Interest is essentially a rental, or leasing
charge to the borrower, for the asset's use.
A rate which is charged or paid for the use
of money

In deposit terminology, the term Interest Rate
refers to a specified amount of money paid by
institutions on the use of cash deposits over a
period of time.
The Interest Rate also consists of the amount
of money a borrower will pay a lender for the
use of their funds over a period of time
Interest is charged by lenders as
compensation for the loss of the asset's use.
In the case of lending money, the lender
could have invested the funds instead of
lending them out.
With lending a large asset, the lender may
have been able to generate income from the
asset should they have decided to use it
themselves.
Interest Rate Example:

For example, an Interest Rate in a country usually reflects the
borrowing cost that its central bank charges commercial banks and
other financial institutions for money that the central bank lends to
them.
An Interest Rate can also be the rate at which these same banks
and financial institutions in turn charge their customers for loans or
pay them on savings and money market accounts.
Financial institutions tend to loan out money at higher Interest
Rates to their customers in the form of credit lines and mortgages,
in addition to providing regular business loans to individuals and
companies. An Interest Rate is usually charged on all forms of
personal financial debt that includes credit card debt, automobile
loans and retailer credit.
Types of Interest Rates
'Simple Interest
A quick method of calculating the interest charge on a
loan. Simple interest is determined by multiplying the
interest rate by the principal by the number of
periods.

Where:
P is the loan amount
I is the interest rate
N is the duration of the loan, using number of periods

Compound Interest Rate:
Compound interest is interest added to
the principal of a deposit or loan so that the
added interest also earns interest from then
on. This addition of interest to the principal is
called compounding.
A formula for calculating annual compound
interest is as follows:

where
S = value after t periods
P = principal amount (initial investment)
j = annual nominal interest rate (not reflecting the
compounding)
m = number of times the interest is compounded per
year
t = number of years the money is borrowed for

As an example, suppose an amount of
1500.00 is deposited in a bank paying an
annual interest rate of 4.3%, compounded
quarterly. Then the balance after 6 years is
found by using the formula above, with P =
1500, j = 0.043 (4.3%), m = 4, and t= 6:

Fixed Interest rate
A fixed interest rate will not change during the
period (term) of the fixed rate that you
choose. At the end of your fixed interest rate
term you can either choose a new one from
the rates available at that time, or change to a
floating interest rate.

Floating Interest rate
A floating interest rate will go up or down as
interest rates in the wider market change. You
can change to a fixed interest rate at any time,
although some types of loans are only
available with a floating interest rate.
Interest rates and Economy
Interest rates aren't what they used to be;
rates a year or even a month ago are different
from those prevailing today in our financial
markets. That's because interest rates flex
with the ebb and flow of general economic
activity.
Interest rates also change in response to the
expectations borrowers and lenders have
about the future level of prices.
.
Changes in the rupee value on foreign
exchange markets or in interest rates abroad
and, of ourse, the closely watched monetary
policy actions taken by the Reserve Bank of
India , all have a pronounced impact on the
level of Indian interest rates.
There are, indeed, a host of factors that feed
into determining the general level of interest
rates.
Interest rates play an important role in our
market economy.
As signals direct the flow of a city's traffic
through a complicated grid of intersecting
streets and avenues, interest rates channel the
flow of funds from savers to borrowers.
Usually, the funds flow through financial
intermediaries such as banks, mutual funds
and insurance companies.
A balance is struck between the demand for funds by
borrowers and the supply of funds from savers by an
ever-adjusting level of interest rates.
Changes in the quantity of funds available to finance
the spending plans of borrowers as well as changes in
borrowers' demands for funds alter interest rates
which, in turn, affect the levels of consumer and
business spending, income, the Gross National
Product, the employment of resources and the level of
prices.
Clearly, interest rates have a tremendous effect on our
economy.
Who Determine the Interest rates ?
In countries using a centralized banking
model, interest rates are determined by
the central bank . ( In India RBI)

In the first step of interest rate determination,
the government's economic observers create
a policy that helps ensure stable prices and
liquidity for the country. This policy is
routinely checked to ensure that the supply of
money within the economy is neither too
large (causing prices to increase) nor too small
(causing prices to decrease).
Because retail banks are usually the first
financial institutions to expose money to the
economy, they are the principal instruments
used by the central bank to manipulate the
money supply. By adjusting the interest rates
on the money it lends to or borrows from the
retail banks, the central bank is able to
regulate the supply of money to the end user
(individuals and companies).
If the monetary policy makers wish to
decrease the money supply, they will increase
the interest rate, making it more attractive to
deposit funds and reduce borrowing from the
central bank.
On the other hand, if the directors wish to
increase the money supply, they will decrease
the interest rate, which makes it more
attractive to borrow and spend money.

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Definition of 'Interest Rate'

The amount charged, expressed as a

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