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Simple Interest: Overview and Calculations

30 Aug 2024

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Ever wondered why you pay those itsy-bitsy extra monies above the monthly EMI or a little more extra on returning borrowed money? That’s because every borrower must pay a rental, or leasing charge to the lender for the asset’s use. That rental is called the interest, and the rate at which it is calculated is called the interest rate.

Interest rate is the amount levied, as a percentage of principal amount, by a lender on a borrower for the use of assets such as cash, consumer goods, vehicle or building etc. In case of large assets like vehicle or building, the interest rate is also know as the lease rate. The value of the interest rate charged depends on the risk evaluation of the borrower. If the borrower is low-risk,then he will be charged a low interest rate. However, if the borrower is considered high-risk, then the interest charged will be higher.

Interest rates are calculated on a yearly basis, also known as the annual percentage rate. Now imagine someone lent you money. From the day of the lending to the day you return the money, the lender will charge an amount (the interest) as compensation for the loss of the asset’s use (money is the asset in this case). Why loss? Because he could have invested the money instead of lending it out to you. He could have been able to generate more income from the money/asset by using the money/asset himself.

How do you calculate interest?

Simple Interest (SI) = Principal Amount (P) x Annual Interest Rate (I) x Years (N)

Thus, interest rate can be calculated by dividing the amount of interest by the amount of principal. For eg, if your bank charges INR 1000 a year on a loan (principal amount) of INR 10,000, then the interest rate would be 1000/10,000 x 100% = 10%

Each bank can determine its own interest rate on loans, but in practice, local rates are approximately same across banks. But it is generally observed that interest rates rise when there’s inflation, increased demand for credit, strict supply of money to the economy, or due to higher reserve requirements for banks. And arise in interest rate invariably dampens

Business activity (because credit becomes expensive);

Stock market(because investors get better returns from bank deposits or newly issued bonds than from share purchase)

Speaking of investors, those investing in debt funds and tax-free bonds are always happy when the interest rates are cut by the Reserve Bank of India (RBI). This points to the fact that a slash or rise in interest rate affects market trends. In a bullish market, a bond is likely to increase in value when the interest rates are declining. And in a bearish market, a bond is likely to decrease in value when there's a fall in the interest rate. Now since market trends cannot be predicted accurately and their impact on stock prices is difficult to assess,the movement of stock prices may defy logic and move in any direction over the threshold. A circuit breaker is a system to sustain sanity of the stock market in such situations.

An upward movement over the threshold will put a stock in an upper circuit. This is advantageous for the investor who has already invested in the stock. Similarly a downward movement beyond the threshold will cause a stock to enter a lower circuit. This places the investor at a disadvantage because it's difficult to sell these stocks as they have lost enormous monies.

So if you are keen on investing in bonds and stocks and other investment instruments for the purpose of securing your future, ensure that you have your eyes glued on the interest rate. After all, why would you want to spend more than you can earn, right?

Note:The current interest rate across Indian banks averages at 6.5%

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