Term Of The Day: Interest Rate

Interest rate is paid by the lender to the borrower for foregoing the consumption of resources until a future date. 

PropTiger Explains Interest Rate

In the context of mortgage finance, interest rate is the price home buyers pay to banks or financial institutions to have money at their disposal. Home loan interest rates are often compounded. When "compound interest" is applied to the principal amount, lenders earn interest on even the interest paid. When interest rates are compounded, the total payment home loan borrowers make over the tenure period is often much greater than the principal amount. 

Even though many assume that central banks like the Reserve Bank of India (RBI) can determine home loan interest rates, this is not true. It is true that the RBI can raise the repurchase rate (repo rate) at which it lends to commercial banks. For example, when the RBI hiked the repo rate, commercial banks raised the interest rates too.

But, there are many other factors that influence interest rates. Fundamentally, interest rates are a reflection of the willingness of individuals, firms and governments to save. When the willingness to save is greater and the willingness to spend is lower in an economy, the demand for funds would be lower. Hence, the interest rates would be lower too. But, when the economy is expanding and the willingness to spend is high, the interest rates would rise because the demand for funds is high.

It is true that inflation influences interest rates substantially because if the value of money erodes over years, banks and financial institutions would be willing to lend money only at a higher interest rate. The real interest rate is the nominal interest rate (officially declared interest rate) adjusted for inflation. This means that the real interest rates would often be lower than the officially declared interest rate.  

In India, interest rates on home loans could applied either at a fixed rate or a floating rate. When the interest rate is fixed, it is often higher, but stable and unchanging. When the interest rate is floating, it could rise or fall depending on credit market conditions and the monetary policy of the RBI.

Check out PropGuide's comprehensive guide to real estate terms here.

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