CONCEPTS ABOUT INTEREST RATE

Interest rate, being the price of money loans is usually determined by the supply and demand for money. On the one hand, the rate of interest depends upon the supply of money available to the community; on the other, it depends on the demand for that money, i.e., liquidity preference. In general, as supply of money increases/rises in relation to demand the interest rate falls and vice-versa.

(a) Simple and compound interest:-

The simple interest is the product of principal, the time in years and the annual rate of interest e.g. the interest of Rs.10,000/- for one year with 10 per cent rate of interest equals Rs.1000 and only one payment of interest is made when loan matures. When simple interest is computed for part of a year then time in years is a fraction, with numerator being the term of loan in days and the denominator is days in a year. The amount is called “exact” simple interest when 365 days or 366 days in a leap year, are used in the denominator of the fraction. But when 360 days are used as denominator of the fraction, the amount is called as “ordinary” simple interest which is slightly greater than the “exact” simple interest.

Compound interest:- Here the interest is periodically “converted into the principal” i.e. annually, biannually, quarterly, etc. The interval between successive conversion is called the “conversion period” and amount due at its end is called the “compound amount”. The “compound interest” is difference between the compound amount and the beginning principal while “compound interest rate” is the rate per conversion period charged on outstanding balance at the beginning of that period.

The amount of interest charged increases with the frequency of compounding and it is very much liked by the lender but disliked by the borrower. The periodic rate or rate per conversion period, referred to as the “compound rate”, is the “True or actuarial rate”. Thus, true rate is charged against the principal in each conversion period and it decreases as the frequency of compounding increases. The annual rate referred as a true rate only when interest is compounded annually.

 (b) Nominal and effective rates:-

The “nominal annual rate or nominal rate” is the periodic rate converted on an annual basis (under the situations of converting interest to the principal more than once in a year). On the contrary, the rate of interest actually earned per annum is called the “effective annual rate” and is obtained by compounding the true rate for a period of one year. The nominal rate though provides a fairly good basis for comparing loans, yet the effective rate is more precise.

(c) Interest on beginning balance:-

For computing the interest on beginning balance there are two methods:

i) Discount method:- The total interest charges are subtracted or discounted from the beginning principal amount and then loan instalments are fixed e.g. with 10 percent interest rate on Rs. 20,000 for a period of 3 years the interest would be Rs.6000/-. Thus, the borrower will receive only Rs.14,000 and instalments would be computed by dividing Rs.20,000 through total number of payments.

ii) Add-on-method:- Here the total amount of interest is added to the principal amount borrowed and borrower initially receives the full amount. The periodic instalments/payments are computed by dividing the principal plus total interest by the total number of payments.