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Interest Rates and its influence on your debt

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Debt is an important avenue which provides finance to individuals, corporates, and governments for fueling their needs like buying a home, increasing a company’s production, financing a project etc. Debt is provided by Lenders like financial institutions, banks and also by individuals, they, in turn, expect a return for lending their money. There are many types of debt channels the common ones are loans and bonds.

As said earlier lenders expect a return for lending their money, this is called interest rate. In a broader economic view, the rate of interest is determined by the demand and supply of money available in the market. Money flows into the market from different channels and there should be an onlooker to monitor and control such demand and supply, here comes the central bank i.e. RBI (Reserve Bank of India) to don the role.

Loan

People take loans in various forms from various financial institutions for their various needs, the most important and common factor over here is the interest rates at which people are taking the loan. The banker or any financial institution will lend you money for a particular rate of interest. So at an individual level, one has to have an understanding what influence does RBI has on their personal finance.

let’s give a thought about it. As we can understand that Indian central bank i.e. the RBI has the major hand in playing with rates, though some economic factors may contribute. The policies of RBI like the CRR, SLR, Repo and Reverse Repo rates etc. change the interest rates to be paid by the borrower who takes loans from banks.

CRR: Cash Reserve Ratio is the percentage of cash deposits that banks need to keep with the RBI on a daily basis. CRR rate is adjusted to handle the inflation in the country’s economy. When CRR is increased, the interest rates also increase as the amount of liquidity in the financial system decreases. A cut in the CRR leads to decrease in the Interest rates which favors the home loan borrowers.

SLR: Every commercial bank needs to maintain a certain amount of funds in some form with RBI which includes cash, gold, government bonds, etc. before they can provide credit to its customers. This measure helps RBI have control over the bank’s credit expansion, keeping it realistic.

Repo rate: RBI lends money to the commercial banks in India by keeping securities as collateral at a given rate of interest which is called as the Repo Rate, the current repo rate is 6.5%, a bank charges 9.5% interest on home loan if the repo rate increases from 6.5% to 7%, the bank may also increase its home loan interest to 10% to compensate its pay to RBI and balance its profits.

The collective impact of all these rates influence the liquidity in the financial system and lead to an increase or decrease in loan lending rates.

The ROI (Rate of Interest) is charged by the bank could be a fixed or floating one. If it’s a fixed ROI loan a defined interest is charged from the borrower throughout the tenure of the loan and in floating the ROI changes accordingly to the changes in economic factors. Both ways have their own pros and cons, for instance, if the borrower opted for a fixed ROI and going further if RBI changes any of the above said policies the gains or losses that result from such changes in the rate of interest are not affected to the borrower. This applies vice versa for a floating rate loan.

Bonds

Bonds are debt instruments which are also affected by the interest rate changes. Interest rates and bond prices are inversely proportional i.e. if interest rates increase the prices of the bond will fall, as the bonds already held by the people don’t value that much compared to new bonds with high rate. Similarly, if the interest rates go down the price of already held bonds are attractive so the price of the old bond increases.

One important factor to consider here is that the Yield of the Bond is also affected by its Interest and in a direct way. This can be understood by an example. Assume the price of a government bond is traded at Rs 1000/- with a coupon rate of 7% i.e. the bond is paying Rs 70/- the yield would be (70/1000)*100 = 7%. Due to economic factors, the interest rates of the bond has increased to 8%, the new 8% bond may trade at Rs.1050/- so the yield will be (80/1050)*100 = 7.61%. so to match up with the new bonds yield competition and to get more attractive the price of the old bond has to be reduced, assuming it has got down to Rs.900/- then the yield would be 7.77% which now becomes more attractive than the new bond.

This is how the interest rates play a vital role in influencing an economy at a large scale and also at an individual’s finance level. Choosing debt as a part of the portfolio in a wise way always helps us to achieve our expectations. As an individual one cannot look into all instruments from the market and cannot choose what is best for him, he may choose a junk instrument instead of a high credit quality instrument as he cannot all evaluate the elements of such instruments. Hence it is always suggested that one should seek professional help while dealing with his personal finance.

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