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How do interest rates work?

Reserve Bank of India is the apex institution that determines monetary policies, on the basis of which, banks set interest rates that are prevalent at a certain point in time within the country.

Updated:March 6, 2019, 1:35 PM IST
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Reserve Bank of India HQ
File photo of Reserve Bank of India headquarters. (Picture courtesy: Twitter)
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Be it deciding the sum of money you would earn on your investments to the amount you’d have to shell out as repayment towards a loan, interest rates have a lot to do in your financial scape.

That being said, what do interest rates actually mean and how do they work? Here is all you need to know about the functioning of one of the more common terms you must’ve come across at different points in time:

What is interest rate?

Interest rates refer to the interest that falls due, for every period, on the money that you decide to borrow, lend or deposit. From the lender’s perspective, interest is the premium that it charges you for taking a risk with their money and lending it to you.

The total interest that is levied on a sum that you borrow or deposit primarily depends on the interest rate, principal amount and the tenor for which it is being borrowed or deposited.

How do interest rates work?

Reserve Bank of India is the apex institution that determines monetary policies, on the basis of which, banks set interest rates that are prevalent at a certain point in time within the country. An array of factors -- rate of inflation, industrial production index -- go in to formulate the repo rate (that is the rate at which the RBI lends to other commercial banks).

Besides the Repo Rate, Cash Reserve Ratio (refers to the quantum of funds banks have to maintain with the RBI), Reverse Repo Rate (the rate at which the RBI borrows funds from commercial banks) and other money market instruments help to control the supply of money in the economy.

How does Repo Rate affect interest rates?

It is primarily basis the above-mentioned rates and instruments that banks decide the rate at which you can borrow or deposit money. In other words, if the RBI brings down the rate at which it lends to banks, lenders would also be able to pass on this benefit to you, in the form of lower rates of interest. However, if the RBI decides to up the repo rate, then lenders would also have to scale up the interest rates on what you borrow in order to maintain profit margins.

Besides, lenders also consider the ‘risk factor’ of lending funds to you. Several parameters such as your credit score, type of loan, level of income, etc. are factored in to arrive at the perceived risk. Here is how some of the factors are dealt with:

Credit Score

A three-digit number, the credit score is determined on the basis of your credit history and indicates your repayment ability. Thus, with a higher credit score (upwards of 750 and more), chances of you sealing a favorable rate of interest on your loan amount are more.

Type of loan

Interest rates also depend on whether your loan is backed by collateral (secured loan) or not (unsecured). To the lender, any unsecured loan is riskier; considering it has nothing to fall back upon should you fail to repay the debt on time. Therefore, unsecured loans generally carry a higher rate of interest as compared to other secured loans.

Level of income

With income on the higher side, you are generally considered a safer bet. The idea behind this is that with an increase in the level of income, affordability improves as well, thereby leading to an increased likelihood of repaying the debt on time.

To know more, click here.

This content has been created in association with YONO SBI.

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