In simple terms, interest is what lenders (banks or other financial institutions) charge you for using their money. The interest rate charged is a percentage of the money that you have borrowed.
So, for example, if you have borrowed Rs. 500, and the interest rate is 10%, then the interest you pay for using the bank’s money is 10% of Rs. 500, which is Rs. 50.
Principal (Loan amount): Rs. 500
Interest Rate: 10%
Interest to be paid: 10% of Rs. 500 = Rs. 50.
Why do interest rates differ?
Interest rates differ by type of loan; by credit profile of customer; and by bank.
Loan: Each loan has a different risk associated with it. For instance, when a bank gives you an auto loan, they hold the vehicle as security until you have paid off the loan in full. If you fail to repay your loan, they can dispose of the vehicle to recover their money.
However, when a bank gives you a personal loan, they do not have any security in case you default on the repayment. They carry the entire risk and have no collateral or asset of yours that they can sell to recover their money. That is why the interest rate on a personal loan is higher than an auto or home loan – lenders are trying to safeguard their risk in case of default by charging a higher rate of interest.
Customer: Similarly, each individual customer carries a different risk for the bank. If you have always repaid your loans in full and on time, your credit history will reflect a high credit score. Banks will recognize you as being a low-risk customer who has a low probability of defaulting on repayments. You might then be offered a lower interest rate as the bank is reasonably confident that you will pay back their loan in full.
Conversely, if you have a low credit score, it signifies that you have a poor record of making repayments. The bank perceives you as being at high risk for repeat defaults and will charge you a higher interest rate to safeguard the money they have lent you.
Bank: Each bank/financial institution determines what interest rates it will charge based broadly on market conditions. Interest rates among banks and other financial institutions are generally in the same range as they need to remain competitive with each other. When banks lend money to an individual or a company, they expect a profit from the money they have lent since they could have invested the same money instead of lending it. This profit from lending is interest.
If the bank sets the interest rate too high, then customers will choose to go to other lenders. If it is too low, then the bank ends up losing money. Thus interest rates remain broadly the same among banks, with individual customers being offered different interest rates depending on their credit profile, among other factors.
What are the main kinds of interest rates?
There are two main kinds of interest rates: Simple Interest and Compound Interest.
Simple interest is calculated only on the actual loan amount (principal). Compound interest is calculated on the principal amount AND the interest accrued on the loan until date.
To take the same example as above where loan amount is Rs 500:
Under Simple Interest:
Interest is 10% of Rs. 500 =Rs. 50.
Every year you pay the same amount, Rs. 50, as interest.
Under Compound Interest
You pay more in interest with each year.
Interest in Year 1 – Rs 50 (same as simple interest)
Interest in Year 2 – 10% of Rs 550 (principal of Rs. 500 + interest of year 1) =Rs. 55
Interest in Year 3 – 10% of Rs 605 (principal of Rs. 500 plus Interest of Year 1 and Year 2) = Rs. 60.50
As the loan tenure increases, the difference between simple and compound interest widens. It is best to pay simple interest as a borrower and to earn compound interest as an investor/lender.