Salary credited! Yay…. Next SMS, EMI debited…. Sigh! The burden of loan EMIs always ruffles the feathers of every budget you create. Taking a loan from a bank takes a few minutes but the looming monthly EMIs makes it no fun (You must have read the ongoing debate on how sometimes even Rs. 1 crore salary package falls short because of rent and EMIs!).. Though the opposite part is something all the saving loving people enjoy, that is the bank interest rates on FDs! Who doesn’t love watching the money grow with as little risk as possible! But did you ever wonder how both loan EMI rates and FD interest rates are calculated by the banks? Is there a science behind bank lending and deposit rates? Or is it yet another complicated data analytics model? Actually, the calculation is tricky but what affects them is super interesting to understand. Like always when it comes to real world applications I love to cover it on The Geeky Logic! So without further ado let’s unravel the mystery behind what affects the bank interest rates and EMI rates.
What are EMIs and FD Interest Rates?
Basics we all know! But a little crux is EMI means equated monthly instalment, it’s the fixed payment the borrower needs to give to the lender each month against the loan they take. Overall when you calculate the total sum paid, it will include the principal amount and some interest too.
FD interest rates are the total opposite. It’s what the banks pay you for keeping your amount as a fixed deposit with them for a certain time period. This interest paid could be monthly, quarterly, annually or even compounded till maturity! Interest is compensation for bearing the risk.
Fun Question: In loans is the annual percentage rate the same as interest rate? Not at all! Annual percentage rate is a step ahead as it includes interest rate plus other charges associated with the loan. That’s why APR is always higher than interest rate!
Did You Know Opportunity Cost Applies to EMIs and Interest Rates?
Coming to EMIs, here the opportunity cost applies to the interest you have to pay. It is the foregone opportunity of utilising the money in the best way at present. Simply, this money if invested elsewhere could have got some other benefits which is opportunity cost lost for you!
Opportunity cost of FD on the other hand has more to do with the risk averse behavior. The potential benefit of earning a better interest in more riskier investments like mutual funds etc., is the opportunity foregone. The preference here is getting a lower interest but keeping the money safer!
Phew! Economics always keeps applying so much to our day to day life and we don’t even realise it!
How are Bank Lending and Deposit Rates Calculated?
On the surface it looks like a simple lending and borrowing thing but this is a super deep concept. Everything is interlinked, these rates not only control the borrowing and lending behaviour but also the inflation which in turn affects the whole economy.
Irrespective of the country, mainly it’s the central bank’s monetary policy and economic factors that can affect both the EMI lending rate and FD interest rates. That means if the EMIs got costly by say 0.75% (shudder!), then there are multiple culprits behind it. Of course monetary factors play the major role when it comes to determining lending and borrowing rates. Mainly there are five!
1. Supply and Demand for Credit Affects Interest Rates
The best theory of economics applies here, the evergreen demand and supply theory. It’s simple maths, if demand for something is higher and supply is lesser, things get costlier and vice versa. Same holds true for these bank rates too! Example, people start investing a lot in real estate due to some market sentiment. As a result the demand for loans goes super high but the banks are limited by some factors and don’t prefer giving so many loans. Final result, the lending rate goes up i.e. EMIs get costlier!
Same thing goes for FDs. Imagine the banks have certain targets to meet in terms of investment but general sentiment has made people more interested in spending more, investing in riskier assets and saving less in FDs. Result? They invest less in FDs which give lesser returns, and the banks in turn may get inclined to increase the interest rates to make FDs more lucrative as an investment!
2. Inflation Rates
It’s a merry go round! Yep! To control inflation, these rates are adjusted and in return these rates can affect the inflation too. For example the wholesale and retail inflation exceeds even more than say 9% (which is generally considered quite unhealthy for the economy!). Then the government and the designated economic policy review committees would prefer that the spending by people gets reduced to control inflation. Result? They can increase the lending interest rate making loans unattractive as EMI gets costlier and at the same time increase the FD interest rates to make savings a better option.
Sweet simple solution to reduce the purchasing power by reducing the spending and increasing the savings!
3. The Repo Rate
In RBI’s MPC meetings all spotlight by the media is on the repo rate! Why? Because it directly affects the interest rates set by commercial banks! When the repo rate is high, banks pass this cost to borrowers, good for FD savers but bad for borrowers. This also helps to cool down inflation. Here’s a bit more about it!
What is Repo Rate?
When you need a loan, you reach out to your nearest bank or financial institution. But what about them? Where do the banks go if they are short of funds and need a loan? They go to their central bank which in India is the Reserve Bank of India. Now the question is at what interest will they get a loan? Here marks the entry of repo rate! Repo rate is the interest rate at which RBI lends money to commercial banks.
P.S.: In the US it’s called the Fed rate cut!
The Mystery of Basis Points in Repo Rate
Often seen in news, we get to know RBI has reduced or increased repo rate by say 50 basis points and that leads us to scratching our heads. What is this? The good part is this is no rocket science, it’s actually a simple percentage. 50 basis points mean 0.50%!
That means if the original repo rate is reduced by 50 basis points, in normal terms it means that there is a reduction of 0.50% in the interest rate at which the commercial banks can borrow from RBI.
4. Your Credit Score Matters Too!
Not relevant to FD interest but this credit score can really impact the lending rates at which bank offers a loan! More often there are certain offers given by banks in terms of a lower interest rate for a loan taken that depends highly on the credit score and a person’s creditworthiness.
The theory is simple. Banks need some kind of trust right? If your credit score highlights that your chances of paying back a loan is higher because of your past good credit behaviour, then they would love to give you a loan at a better interest rate too!
P.S.: Did you know a simple thing like missing the deadline of a credit card repayment negatively affects the credit score?
5. Types of Loans and Level of Risk Affects the Interest Rate as Well
Yep! Not all loans are the same! Once again this point applies more to EMIs and not the FD interest rates. The idea is super simple. The riskier the chances of loan not being repaid, the higher the lender will charge an interest. After all, they need to safeguard their money too! Example time! Suppose a person wants to take a personal loan, chances are it can attract an interest rate as high as 12-40%, while if the loan is for something like buying a house or a car, the interest rate is generally lower. Simply because in case of failure of repayment of the latter loan, the lender can recover the money by selling the asset which is missing in the former loan!
P.S: Credit card interest rate is also generally higher because of this reason only!
Bonus point: Who is the Consumer Matters Too!
Yes, banks treat people differently when it comes to offering both the FD interest rates or giving away a loan at a lower interest rate. Individuals, businesses, even governments are treated differently as a customer!
Fun fact: Did you know unknowingly you are a lender too? Confused? Here’s an example: when you open a bank account, you get some interest. Your money is used by the bank to invest elsewhere and get some returns, so you become a lender and in turn the bank gives you some interest as a reward! When you open an FD too, you become a lender to the bank that’s why you get the interest! Cost for one is income for another.
Not so Common Factors That Affect Bank Lending and Deposit Rates
Monetary and economic reasons we all got it covered but there are actually many other reasons behind the calculation of loans interest rate and FD interest rates too. Here are a few:
The Market Sentiment
Many times the market conditions play an important role. For example many people start deferring their credit card payments due to market sentiment. It’s a small issue but when many people start doing it this can affect the interest rates.
Market Competition
Yes, banks are competitive too! After all they have to achieve certain targets as well just like all businesses do. That’s why many times some banks may offer better interest rates to get an edge in terms of getting more customers than their competitors.
Bank Liquidity
Banks need money to meet their short term financial obligations as well which is called the bank liquidity. The biggest example is you going to a bank to withdraw cash, banks need that kind of liquidity to meet short term needs. This bank liquidity varies from bank to bank and it can affect the interest rates being offered too.
Global Economic Trends
The chances of not being affected by international economic trends is zilch! Like all economic factors the global economic trends can affect the monetary factors which in turn affect the interest rates!
Economic Conditions
The real numbers like unemployment rate, GDP growth etc., affect the country’s overall growth and can play a major role sometimes in directly and indirectly affecting the interest rates. Bullish and bearish economy makes an entry here!
Age of the Borrower
This holds true in case of EMI, but yes, banks may offer a loan at a comparatively higher interest rate if the age of the borrower is high, because the tenure and risk involved gets affected as well.
What is No Cost EMI?
Interest becomes the discount! Also called zero cost EMI, it basically means you can purchase a product by paying in installments but at the same time you don’t have to pay any additional interest charges. In short the interest is waived off so you sought of get a discount by paying no interest!
For example, you bought a TV worth Rs. 40,000 on no cost EMI for 4 installments. It will allow you to pay Rs. 10,000 monthly for 4 months even though you get the ownership of the TV immediately! This concept of zero cost EMI has become really popular, especially because it helped in increasing the purchasing power for everyone!
The whole idea of understanding bank lending and deposit rates was mainly because of the journey of understanding the RBI’s repo rate! The concept itself was so interesting and how much it impacted the EMIs and FD interest rates which in turn impacted the saving and investment behavior was amazing to discover. Be it businesses, entrepreneurs or individuals, everyone is affected by these interest rates. Am sure next time you take a loan or invest in an FD, you would definitely remember this blog (hopefully!). How was your first saving experience? Do share in the comments section below.
P.S.: Your money is precious! Always take loans or save money in FDs with only verified registered institutions preferably commercial or government banks!