How to capitalise on changing interest rates? | Basics
Do best investing by understanding fluctuating nature of cost of capital
Hello, 👋
FD is always good. No, equity investment is always better. If you have such ‘always’ beliefs, this article is for you. The definition of better depends on multiple factors and interest rate is the major one.
Here, I tried to understand what interest rates are and how they can influence my purchase and investment decisions. Enjoy!
Garvit Sahdev enjoys understanding ideas that shape our world. The Thoughtful Tangle is an initiative to share this journey and experience with his friends who love to do the same. He selects one idea and dives deep into it to understand its basics, relevance, impact and opportunities around it. The thoughtful tangle is special because 👇
📝 One long article per idea. We call it ‘The Basics’.
📝 Multiple unique insights. Separate small articles for special ‘Insights’.
🧑🤝🧑 Experts perspective. Check out ‘Insiders’
What is Interest Rate?
Interest rates are the extra money you pay when you borrow money, or the extra money you earn when you save money. They're shown as a percentage of the total amount. For example, if you borrow $100 with a 5% interest rate, you'll have to pay back an extra $5.
Interest rates affect how expensive or cheap it is to borrow money and how much you earn from savings. When interest rates are high, borrowing is more expensive, but saving is more rewarding. When interest rates are low, borrowing is cheaper, but savings don’t grow as much.
Understanding interest rates helps you make better choices when borrowing or saving money.
Type 1: Simple Interest
Simple interest is a way of calculating how much extra money you have to pay when you borrow money, or how much you earn when you save money. It’s called "simple" because it only takes into account the original amount of money (called the principal).
Here's how it works:
Formula: Interest = Principal × Rate × Time
Principal: The original amount of money you borrowed or saved.
Rate: The percentage of interest you have to pay or earn.
Time: The length of time you’ll be paying or earning interest.
Example:
If you borrow $1,000 at a 5% interest rate for 3 years, the interest would be:
$1,000 × 0.05 × 3 = $150
So, you’d pay $150 in interest over those 3 years. The interest doesn’t change; it stays the same each year because it’s only calculated on the original amount.
Type 2: Compound Interest
Compound interest is a way of calculating interest where you earn or pay interest not just on the original amount (the principal), but also on any interest that has already been added. This means your money can grow faster over time.
How It Works:
Principal: The original amount of money you start with.
Interest Rate: The percentage at which your money grows.
Time: How long your money is invested or borrowed.
Example:
Let's say you put $1,000 in a savings account with a 5% interest rate. In the first year, you earn $50 in interest (5% of $1,000). In the second year, you earn interest on $1,050 (the original $1,000 plus the $50 interest from the first year). So, you’ll earn $52.50 in the second year.
This process repeats, with the interest adding up each year, making your money grow faster than with simple interest, where interest is only calculated on the original amount.
Simple Breakdown:
Year 1: $1,000 + $50 = $1,050
Year 2: $1,050 + $52.50 = $1,102.50
Year 3: $1,102.50 + $55.13 = $1,157.63
Over time, compound interest can significantly increase your savings or the amount you owe if you're borrowing.
Annual Percentage Rate (APR)
Annual Percentage Rate (APR) is the total cost of borrowing money over a year, including not just the interest, but also any additional fees or charges. It’s shown as a percentage, making it easier to compare different loans, credit cards, or mortgages.
Why APR is Important:
Shows the True Cost: APR gives you a clearer picture of how much you’ll really pay over time because it includes all the extra fees, not just the interest rate.
Comparison Tool: When you’re looking at different loans or credit cards, you can compare the APRs to see which one is cheaper overall.
Example:
If one credit card has a 15% APR and another has a 20% APR, the first one is cheaper because you’ll pay less in interest and fees over a year.
In short, APR helps you understand and compare the real cost of borrowing money, so you can make smarter financial decisions.
Marginal Cost of Funds-Based Lending Rate (MCLR)
This is the minimum interest rate that banks can charge their most creditworthy customers, like big companies or reliable borrowers.
How It Works in India:
Influenced by the RBI: The Reserve Bank of India (RBI), which is India’s central bank, plays a big role in setting these rates. When the RBI changes its key rates, like the repo rate (the rate at which the RBI lends to commercial banks), it influences the MCLR and base rates. This affects how much interest banks charge their customers.
Application: Banks use the MCLR or base rate to decide how much interest to charge on loans like home loans, business loans, or personal loans. If you have a good credit history and are seen as a low-risk borrower, you’re more likely to get a loan at this base rate.
Example:
Let’s say the MCLR in India is 7%. If a reliable business wants to take a loan, the bank might charge them around this rate. However, if the business is seen as riskier, the bank might add a small percentage above the MCLR.
Why It Matters:
For Borrowers: Understanding the MCLR or base rate helps borrowers know whether they’re getting a good deal on their loan.
For the Economy: Changes in these rates can influence how much businesses and consumers borrow and spend, which in turn affects economic growth.
In simple terms, the MCLR or base rate in India is like a benchmark that banks use to determine loan interest rates, heavily influenced by the policies set by the Reserve Bank of India.
Nominal interest rates and real interest rates
Nominal Interest Rate:
This is the interest rate you see advertised by banks or mentioned in loan agreements. It’s the basic percentage that tells you how much extra money you’ll have to pay when you borrow, or how much you’ll earn when you save.
For example, if a bank says it offers a 7% interest rate on a fixed deposit, that 7% is the nominal interest rate.
Real Interest Rate:
The real interest rate takes inflation into account. Inflation is the rate at which prices for goods and services increase over time, reducing your money's purchasing power.
To find the real interest rate, you subtract the inflation rate from the nominal interest rate.
If the nominal interest rate is 7% and the inflation rate is 5%, here’s how the real interest rate works from both the borrower's and lender's perspectives:
Real Interest Rate Calculation:
Formula: Real Interest Rate = Nominal Interest Rate - Inflation Rate
Calculation: 7% (Nominal Rate) - 5% (Inflation Rate) = 2% (Real Interest Rate)
From the Borrower’s Perspective:
The borrower pays 7% interest on the loan, but because inflation is 5%, the real cost of borrowing is actually lower.
Effectively, the borrower is paying a 2% real interest rate, which means that, after considering inflation, the true cost of the loan is only 2%.
From the Lender’s Perspective:
The lender receives 7% interest on the loan. However, due to 5% inflation, the money they get back is worth less.
Effectively, the lender is earning a 2% real interest rate, meaning that after adjusting for inflation, their real earnings from the loan are only 2%.
In Simple Terms:
For the Borrower: Inflation helps reduce the real cost of borrowing, so the loan is cheaper in real terms.
For the Lender: Inflation reduces the real return on the money lent, so the lender earns less in real terms.
Impact of Interest Rate Increase
Borrowing Costs:
When interest rates go up, it becomes more expensive to borrow money. For example, if you take out a loan or a mortgage, you'll have to pay more in interest.
Savings:
Higher interest rates mean you earn more in your savings. So, if you have money in a savings account or fixed deposit, you’ll get better returns.
Consumer Spending:
As borrowing costs increase, people often spend less because loans are more expensive. This can lead to a decrease in overall spending.
Inflation:
Higher interest rates help control inflation. When people borrow and spend less, it reduces the overall demand for goods and services, which helps keep prices from rising too quickly.
Stock Market:
When interest rates rise, it usually causes the stock market to fall. This happens because higher borrowing costs can reduce the profits of companies, making their stocks less attractive to investors.
When Interest Rates Decrease
Borrowing Costs: Decrease (cheaper loans, mortgages).
Savings: Less attractive, lower returns.
Consumer Spending: Increases as borrowing becomes cheaper.
Inflation: May rise due to increased demand.
Stock Market: Generally, rises as companies have access to cheaper capital.
What to Do When Interest Rates Change
Interest rates can impact on your finances in various ways. Here’s a simple guide on what to do when interest rates go up or down:
When Interest Rates Increase
Borrowing:
Lock in Fixed-Rate Loans: If interest rates are rising, it’s smart to secure a fixed-rate loan now. This means you lock in a set interest rate for the life of the loan, so you won’t be affected by future rate increases.
Example: Suppose you’re buying a house and the current mortgage rate is 4%. If you expect rates to go up, locking in this 4% rate ensures you’ll pay this rate even if rates rise to 5% or more in the future.
Saving:
Consider Long-Term Savings Accounts: When interest rates rise, banks offer better returns on savings accounts and fixed deposits. Look for accounts with higher rates and consider putting your money in for a longer term to take advantage of these higher rates.
Example: If the interest rate on your savings account rises from 2% to 4%, moving your money to a new account with the higher rate will earn you more interest.
Investing:
Focus on Income-Generating Assets: Higher interest rates make bonds and real estate more attractive because they provide stable returns. Consider investing in these types of assets. (See next section)
Example: If you invest in bonds, higher interest rates mean you’ll get more money from bond payments. Similarly, real estate investments can offer good returns as people may seek rental properties.
When Interest Rates Decrease
Borrowing:
Refinance Existing Loans: When interest rates drop, you can refinance (replace) your existing loans or mortgages with new ones at the lower rate. This reduces your monthly payments and the total interest paid overtime.
Example: If you have a mortgage at 6% and rates, drop to 4%, refinancing your mortgage can save you money by lowering your interest rate and monthly payment.
Saving:
Explore Alternative Investments: Lower interest rates mean savings accounts and fixed deposits may offer less return. Look for other investment options that have higher potential returns, like stocks or mutual funds.
Example: Instead of keeping your money in a low-interest savings account, you might invest in a diversified mutual fund that has the potential for higher returns.
Investing:
Focus on Growth Stocks or Assets: Lower interest rates make borrowing cheaper for companies, which can boost their growth. Investing in growth stocks or assets that benefit from lower borrowing costs can be profitable.
Example: Tech companies often borrow to fund expansion. Lower interest rates make borrowing cheaper, which can lead to higher growth and potentially higher stock prices.
When interest rates go up, certain types of investments become more attractive because they offer stable and predictable returns. Two key examples of income-generating assets are bonds and real estate. Here’s why these assets are appealing when interest rates rise:
Bonds:
How Bonds Work:
Bonds are like loans you give to companies or governments. In return, they pay you interest, known as the coupon rate, on a regular basis until the bond matures.
Example: If you buy a bond with a 5% coupon rate, you earn 5% interest on your investment each year.
Why They’re Attractive When Rates Rise:
When interest rates rise, newly issued bonds offer higher coupon rates. If you already own bonds with lower rates, they become less attractive compared to new ones.
Opportunity: If you invest in bonds after interest rates have risen, you can secure higher coupon rates, which means more interest income.
Real Estate:
How Real Estate Generates Income:
Real estate, like rental properties, can provide a steady income through rent payments. Investors buy properties and rent them out to tenants.
Example: If you own a rental property, you collect monthly rent, which serves as a steady income stream.
Why It’s Attractive When Rates Rise:
Higher interest rates can increase the cost of borrowing, making it more expensive for new buyers to purchase properties. This can reduce competition for real estate, potentially lowering property prices.
Opportunity: As borrowing costs rise, fewer people may buy homes, which can make rental properties more attractive. Additionally, if you already own property, you benefit from higher rental income, as tenants may face fewer alternatives.
SOMEONE CAN BENEFIT FROM IT
If you find this post helpful, we would be grateful if you could take a moment to share it with others who might benefit from it. Your kindness and support mean a lot to us.
DYNAMIC CONTENT
No one knows how deep a rabbit hole can go.
All our posts are regularly updated as soon as new information becomes available. We also keep note of the questions asked by our readers and add their answers to the article. So, stay curious and ask questions in the comments.
ABOUT THE AUTHOR
Hey everyone, I'm Garvit Sahdev 😎. I'm on a mission to gain a deeper understanding of the world, and to develop solutions that can trigger significant global change.
My curiosities span various domains including food, business theories, material science, market size calculations, economics, politics, and sports, etc. 🧐
Professionally, I have a diverse background spanning startups, consulting, policy development, market research, system building, ISO, colour physics, nanomaterial synthesis, textile chemistry, etc. 🐘
Note: Generative AI has been used for writing this piece under the supervision of the author.
Thanks for reading The Thoughtful Tangle! Subscribe to continue reading deeply researched stories about the interesting concepts that shape our world. ❤️