Friday, 21 October 2016

Factors that impact the interest rates

Factors that impact the interest rates!

If you want to spend more money than the actual cash in hand you have, you will need to find someone willing to lend his surplus funds. For you as a borrower the interest rate will be the cost of borrowing money. It is the price that you will pay for gaining the ability to spend the money now instead of waiting for the time when you are able to save enough.  For example taking a home loan to purchase a house will enable you to own the house now, instead of waiting for the future when you accumulate enough cash. For the lender it is the protection against inflation and a compensation for bearing the risk of lending money. The purchasing power of the money lent today may decrease in future if there is a rise in inflation. Interest income covers for such risks and compensates the lender for forgoing the opportunity of earning money from investments that could have been made with the loaned amount.
The interest rates keep changing. While the rise and fall of interest rates is very difficult to predict they mostly reflect the changes in monetary policy, fiscal policy and economic growth of a country. They also differ based on the type of loan and the length of the repayment period. These factors that bring about changes in the interest rate are explained below.
Demand and Supply
Typically interest rates are determined based on the demand and supply of money in the economy. If the demand exceeds the supply of funds available to be loaned, interest rate rises until it reaches a state of equilibrium. Conversely an increase in the supply of money will lower the interest rates.
When people deposit their money in the bank, they are actually lending funds to the bank to use it for various investment activities. Since banks have more money to lend out to borrowers, more credit is available in the economy. As the supply of credit funds increase the rate of interest decreases.
Monetary policy and intervention by the government
The central bank of the country that is the RBI controls the liquidity in the market through its monetary policy. When it loosens the monetary policy and expands the money supply, interest rates get reduced and people are attracted to spend more money. This brings a spur in the economic growth. When it tightens the monetary policy, liquidity reduces and interest rates increase leading to a lower economic growth and reduction in inflation. Based on the economic conditions RBI changes its key policy parameters-repo rate, CRR and SLR; to bring about a balance in the money supply. These parameters serve as a benchmark for the bank’s interest rates.
Government also manipulates the supply of money in the economy through open market operations. By purchasing large amount of government securities it increases the money supply and by selling those government securities it reduces the supply of credit. This has a direct effect on the interest rates.
Growth in the economy 

The economic growth in the country has a profound influence on the interest rates. When the economy is prospering the confidence level of people to borrow and spend money is high. The demand for funds increases thereby pulling up the interest rates. During economic slowdown people tend to borrow less and spend less. As the demand for investment and consumption in the economy declines so do the interest rates.


Another important factor that governs the movement of interest rate is the rate of inflation. As the cost of goods and services increases over a period of time the purchasing power of the currency gets reduced. In order to protect the returns of investment against the risk of inflation the interest rate that lenders charge on the loaned amount exceeds the inflation rate. This compensates them for the decreased purchasing power of money that is repaid to them in future. Therefore when inflation rises so do the interest rates.
The interest rates also vary depending upon the amount of credit risk on different types of loan. In case the loan is secured the risk level of the lender is less so the interest rate levels are low. In case the risk of default is high then interest rates tend to increase to cover for that risk. If the lender is lending money to a person with a low credit score who has a history of late payments then he is at a greater risk of losing out on his investment. He will therefore charge a high interest rate to compensate for the higher risk that he is taking.

While most of the factors that affect interest rates are beyond our control, one thing that we can do to ensure that we get the lowest interest rates on borrowed amount is to maintain a clean credit history. A person with a good credit score can always bargain for the lowest interest rate possible when he shops around to borrow funds.

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