Interest rates have been in the fore for quite some time now, owing to their effect on stock markets, economic growth etc. Let’s see why interest rates are so crucial and how interest calculations are carried out.
Simply put, Interest is compensation to the lender and a percentage of the amount is paid or charged when money is lent. The borrower pays the interest and lender charges it. The rate (percentage) is on the total amount borrowed and is usually expressed as an annual percentage.
Various micro and macro factors are considered to arrive at the appropriate rate. Borrower’s creditworthiness is one of the most pivotal aspects in arriving at the rate. A borrower posing a higher risk of default is charged a higher rate as compared to a borrower with a relatively lower credit risk. The tenure of debt also influences the rate to be charged. Longer term debts are considered to be more risky and attract higher rates of interest in contrast to short term debts. Collaterally secured debts are lent at lower rates as compared to unsecured debts. A key macro factor influencing rate calculations is Inflation. Rise in inflation being imminent over long term, lenders expect higher returns fostered by higher interest rates for long term debts.
As witnessed in the recent past, rate plays a huge role in the development of economy. Lower interest rate regime usually enables cheaper credit to all borrowers thereby rendering more disposable income which spurs purchasing power and in turn economic growth surges.
Numerous investment options generating good returns are available in the form of debt securities. These debt instruments include government and corporate bonds, certificate of deposits, banker’s acceptances, treasury bills, commercial paper etc. Debt instruments usually pay either a fixed rate of interest or have a floating rate. Fixed rate securities have a fixed interest and a fixed maturity period where as floating rates instruments pay a variable rate of interest and the rate is reset according to the payment period.
Interest rates on debt securities are calculated broadly in three ways. Discount method, yield based method and bond market calculations. Money market instruments like commercial paper, treasury bills, banker’s acceptance etc use discount method while certificates of deposit, bank deposits incorporate yield based method.