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Interest Rate

Interest rate: Understanding the concept

It's Friday, and it's your turn to do the dishes at home. But it's also your friend's birthday. You know what that means, don't you? – Party Time!

So, you strike a deal with your sister. If she does the dishes today, you will not only do her share of the dishes tomorrow but also do half of them the next time it's her turn. Wait, why should you offer to do more?

Well, your sister needs an incentive to do your dishes. Just switching out the days may not work for her. You have to give her more to motivate her to do your work for you.

The incentive you gave your sister is the interest you pay in the world of finance.

Let's dive deeper into this with an example.

Say you go to the mall with your friends and spot a beautiful, silver-strapped watch. Your old watch was damaged the last time you played football, so you need a new one. So, you ask the shopkeeper for the price and he says it's Rs 2,000.

You decide that you must have this watch, because:

  • You need a new watch since your old one is broken.
  • It's the most beautiful watch you have ever seen, and you can't imagine settling for something else.

You see, when it comes to money, nothing is free. So, when you borrow money from someone, say a bank, you need to give them an incentive or a motivation to hand you that money. That's why you give them a little more than what they are lending you and that's the 'interest.'

This additional cost known as interest is the extra dishes you promised your sister you would wash.

But you have only Rs. 1,200 with you at present, which is not enough to buy it.

So you borrow Rs 800 from your friend and promise to return it next month, the minute you get your pocket money.

Your friend agrees but says she will charge you a monthly interest rate of 5%. This means that you have to pay her back 5% more than what you borrowed.

Since your friend lent you the money, she is the lender. As the person who borrowed the money, you would be the borrower.

The amount of Rs 800 that you borrowed from your friend is called the principal. The 5% extra that your friend is asking to give you that money is called the borrowing or interest rate.

Get your pencils or calculators out

If you want to calculate the exact interest amount, you simply multiply the principal with the interest rate and time or tenure of the loan.

Interest = Principal x Interest rate x Time

So, the interest you owe your friend at the end of the month is Rs 800 x 5/100 x 1 (Remember, when it’s a percentage, it is out of 100) = Rs 40.

You will have to return both the principal and the interest to her, which means she will get back Rs 840. You paid your friend Rs 40 extra so that you could have the watch today.

If you cannot repay your friend the next month, you will have to pay another month's interest.

Apply the interest formula:

Interest = Rs 800 x 5/100 x 2 = Rs 80.

You will end up paying her Rs 880 at the end of two months. A little more expensive for you, but all's well that ends well, right?

What your friend charged you here is called simple interest. In simple words, here, the interest rate is applied only to the principal amount.

Now when you borrow money from banks, they charge compound interest. That means they charge you interest on interest pending.

Here’s what it would look like

Money owed = Principal + (Principal x Interest Rate x Time)

Let’s go back to the example with your friend.

Say your friend was charging you compound interest on the Rs 800 you borrowed.

For the first month, the money you owe remains the same.

Money owed = Principal + (Principal x Interest Rate x Time) = Rs 840

For the second month the total money owed becomes your new principal.

So the interest you will owe will be Rs 840 x 5/100 = Rs 42.

Now, the total amount you owe would be Rs 882.

If you don’t repay at the end of two months and the money becomes due at the end of three months, then Rs 882 becomes your principal. And so the story goes…

This way, you are paying interest on interest which means your interest is compounding.

What happens when you deposit money in a bank

When you borrow from a bank, they will usually charge you an annual interest rate. This means that interest will be calculated for a year or 12 months.

Now, if you had borrowed the Rs 800 from a bank at an interest rate of 6% per year, then at the end of a month, the interest due would be = Rs 800 x 6/100 x 1/12 = Rs 4.

So far, you've looked at what happens when you borrow money and have to pay interest. But is there a way to earn interest?

The cool thing about interest is that you can earn it too! Just that your role needs to be reversed. You need to go from being a borrower to a lender.

Remember how we spoke about savings in the first chapter? Now, if you have excess savings, you can lend it to others and earn interest on it. This is known as an investment.

This isn’t all there is to money and investing. There’s lots more that we will cover in the upcoming chapters.