Five Minutes to Understanding Interest Rates

What is interest rate?Have you ever thought, why should a bank pay you to keep your money safe? Should you not be paying a fee for the safek...

What is interest rate?
Have you ever thought, why should a bank pay you to keep your money safe? Should you not be paying a fee for the safekeeping function of the bank, like when you take a locker in a bank? The reason is simple, you get interest because the bank has access to your money and can use it to earn even more money, unlike the gold in the locker. Why the bank pays is clear, but why do you need interest?

Interest is the price the borrower has to pay to compensate the lender for three main things:

1 Deferred consumption. By agreeing to lend Rs one lakh, you are not using this money today. For postponing your consumption, you need some compensation.

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2 Loss of purchasing power. The Rs one lakh you lend today will be worth less in one year due to inflation. When you lend, you lose purchasing power, for this you need to be compensated.

3 Risk of default. The borrower may simply run away with your Rs one lakh. You need some compensation against this risk. That is the reason that the government paper should pay the least interest – the risk of default is zero.

Interest, or the price of money, is the sum of these three needs of compensation that a borrower has. Not surprisingly, as the time between lending and repayment increases, the interest increases – bank deposits for a year pay less than those for five years. As the risk of the borrower increases, so does the interest rate. As inflation rises, so should the interest rate.

Nominal vs real interest
Interest should be seen after including the effect of inflation. For example, the 5 per cent interest you get when you lend is worth less due to the effect of inflation. If inflation is at 4 per cent, your money earns just about 1 per cent real return. The effect of inflation is particularly harsh to money left in savings bank deposits that earns 3.5 per cent. The money actually loses value if inflation is more than this rate, which is usually is. While fixed interest financial instruments like bonds, debentures and deposits give low real rates of return, the equity market, on an average, gives good real rates of return.

Annual vs periodic compounding
The number of times in a year that interest is calculated and then credited to the money lent, makes a difference in the total rate of return. Suppose you put Rs one lakh at the beginning of the year and after one year, the bank paid you 5 per cent on this. You would get back Rs 1,05,000. Now suppose that the bank calculated a proportionate return each month, that is, it paid you 0.42 per cent (5/12) per month. You get back Rs 1,05,107. The extra seven rupees is the interest on the interest earned. So try and choose instruments that compound more often rather than a once a year compounding.