Interested in interest?

A friend of mine recently took a home loan worth ₹25,00,000 at 7% p.a. for a period of 10 years. She shifted to her new place and was super excited about the fact that she had a space that she can call her own. While I was happy for her, but being a ‘concerned’ friend I thought of looking into the math. Upon enquiring, she told me that her total interest payable would be ₹9,83,255. This means that on a loan of ₹25,00,000, her total interest if taken together over 10 years is about a whopping 39%. Now, what if the bank charged interest at 8% p.a.? The total interest payable in that case would be ₹11,39,829. If you had to take this loan, do you think this would be a feasible condition for you? Interest rates impact our financial goals in a huge way. Even a small percentage change can have a significant effect on all the financing decisions that we take. But, what is the mechanism behind the constantly changing interest rates prevalent in the market? How do we mitigate against interest rate risks? Let’s find out!

The Game Of Interests 

What if you were given an offer wherein you had to choose between the two? Getting a lump sum of ₹1 crore today or getting money in a sequence like ₹1 on the first day, ₹2 on the second day, ₹4 on the third day, and so on for 30 days straight. On an instant, most of us will opt for the first option. Let’s do some math (again). If we choose the second option, our total earnings come up to ₹53,68,70,912.. So you see how much difference even a tiny growth in our income can make? This is how interest rates on savings and investments help us increase our earnings. They provide us with an addition to our earnings consistently and help in optimising the use of our idle money.

It is said that in life, we

 receive much more than what we have given. But when it comes to interest rates, the not-so-interesting fact is that the interest charged on borrowings is nearly double to what is offered on savings. 

Interest costs mostly depend upon demand and supply conditions in the market, Government directives, measures adopted by the Central Bank, inflation, principal sum, term to maturity, the amount of collateral, and the default probability of an individual among others.

 

If the interest rate charged on borrowings is high, then the cost of borrowings increases and more money goes out on interest payments. This limits the consumer spending and ultimately leads to a dip in overall economic growth.

An increased interest rate on savings attracts savings. Majority of Indians still rely on bank deposits for investment purposes. If given an option, wouldn’t you prefer keeping your money safe and sound in a Savings Account that offers a really high interest rate? Why invest your money into other comparatively riskier options? This is why banks try to offer competitive interest rates for the depositors and use our savings to earn more profits for themselves. 

Here’s another point that should be considered. Low interest rates on fixed-interest investment options act as a good stimulator for the stock market. As investors, we are expected to pool in our investments in options that generate higher revenue for us. So, to increase the inflow of income, investors will shift their funds from these low income generating avenues to the stock market. This, in turn, will raise the stock prices, making the economy healthier.

 

 

Our stakes in this game, you ask?

Interest rate indirectly influences inflation as well. If the interest rate on savings is slashed, consumption will naturally increase and savings will drop. Here consumption does not only include general expenditure but investment spendings as well. When the earnings on savings fall, people tend to look for alternative sources of investment avenues like gold, which stays unaffected by interest rate fluctuations. Similarly, if loan interest rates go down, borrowings will become less costly, thus, more people opting for it. Ultimately, the demand for goods and services will rise leading to skyrocketing prices. Like we learnt earlier, this is how inflation comes into the picture. With inflation making an entry to the scene, our purchasing power hits the floor. 

In the words of Dave Ramsey, “A lower interest rate doesn’t make a debt go away.” Loans never come for free. Even if the costs seem to be negligible, high chances are that they are hidden in the loan somewhere. 

Interest rates can also be an absolute spoilsport to any financial plans that we might have. It is imperative to factor it in while chalking out any plans. An efficient financial plan is one that takes interest rate changes into consideration while laying down the framework for achieving our financial goals. We have earlier seen how increased interest rate on borrowings trigger a greater cash outflow. Similarly, if there is an increase in the interest rates of the investments that we have planned to put our money into, it can help us reach our goals faster and more efficiently. Not sure how to make the pitch-perfect plan that guides you towards that financial goal of yours? Read ‘Financial Planning: Worth the Effort?’ and get a clear picture of the financial planning process.

Financial wellness is like a puzzle. Even if a single piece gets messed up, the rest don’t fit right. So, consider even the teeny-tiny aspects before making any financial decision, and rest assured your money will remain safe and sound. 

Team Investoday