Nothing like free money exists in the real world. So if you are borrowing a certain amount of money you will have to pay a little amount out of it back to the lenders. The bit of amount returned back to the lender is known as interest which is calculated as a percentage of original sum borrowed. If in case you are lending your money to an individual or saving a portion in the bank then you can also expect to earn interest against it.

All about interest rates

Whenever you are looking forward to borrowing or saving money then you will come across the word interest and interest rates. Central banks also use the interest rate to influence monetary policy and also to control inflation within an economy. Their decisions are also impacted by the interest rates prevailing in an economy.

Types of interest rates

There are different types of interest rates brief about each one has been mentioned below:

1. Base rate: It is the rate through which banks can borrow money from the central bank. Commercial banks are also influenced by the rates; however, they have the freedom of setting their own interest rates definition for saving and lending to its customers.

2. Nominal or simple interest: This is based on the original amount which is borrowed or saved by the individuals or parties to the bank. The formulae to calculate simple interest is principal x annual interest rate x years. If you have saved an amount of Rs 1000 at an interest of 7 for 2 years then, in this case, Rs. 140 would be earned as total interest and Rs.70 for one year.

3. Compound interest: Herein the interest is calculated every year by working out on principal and accrued interest. The formulae for calculating compound interest is (principal + accrued interest) x annual interest rate.

How do interest rates work?

Interest is applied to the unpaid portion of a loan or balance finance borrowed from the loan provider. For a borrower it is important to stay informed on the interest rates and how is it impacting their outstanding debt. Like if the borrower pays an amount which is less than his interest rate, then it might lead to increase in debts and liability.

Even though the component of interest rate is competitive, they never remain the same always. Banks charge a higher amount of interest especially when they foresee a lower chance of debt is going to get repaid. Loans like credit cards have higher interest rates because they tend to be riskier and difficult to manage for the banks.

The amount of interest charged is greatly impacted by the credit score an individual has. Hence it is important to keep an eye on the credit score and take steps to improve it. Higher your score is, a lower interest rate is imposed on an individual. Apart from this, banks have also the freedom to impose fixed or variable rates on borrowers. The type of interest rate charged varies on the loan i.e. if it is a mortgage, unpaid bill or credit card.