Before delving deeper into interest rates, it is interesting to grasp how lenders know whether they’re dealing with a risky borrower. How do they benchmark one borrower vs. the other? Why do they reduce your interest rate when you jointly borrow with your spouse?
Formalized lenders such as banks refer to the borrower’s “credit score” while taking such decisions.
Credit score is a metric of performance which can be determined for a person, a company, or the government. It is essentially a number which captures your credit “worthiness” by analyzing your credit “history” and customer profile.
Credit worthiness means how less of a risk you are in terms of propensity to repay in full and on time. Credit history here indicates your track-record of repayment on your prior obligations.
If you regularly use your bank account, take loans, or use a credit card, your credit score would be calculated and tracked. Each time you miss a credit card payment, your score will fall. Each time you delay your EMI payment, your score will drop. When your score reduces, the next loan you take will attract a higher interest rate than earlier.
There are credit scores (or ratings) for corporate legal entities and even for specific bond issuances.
Moody’s, S&P, and Fitch are global credit rating companies, which set ratings for major corporations and International bond markets. Companies like Experian, Equifax, Highmark, and CIBIL set credit scores for people, which banks can access before sanctioning loans.
Therefore, when your next credit card bill is due – don’t just pay the minimum amount due, pay the full amount…and preferably BEFORE your due date. Trust me, it all adds up!
Now, how do interest rates manifest themselves into our daily lives?
Though at a high level they move as per the country’s Central Bank and Government finances, interest rates have a very real impact on our personal finances. Most of us would encounter them when we look at saving, borrowing, and investing. I will try to cover each header in the next few weeks through these articles. For this week’s edition, let’s kick-off by looking closely at savings and fixed deposits.
Interest rate on a Savings Account would usually be expressed as a fixed rate you will earn on the monies deposited by you. The bank conceptually treats your deposit as a loan you’ve advanced to them, paying some additional interest back in return. I obviously talk in extremely simplistic terms here…completely omitting the notion of Time Value of Money – to be covered at a later stage.
Banks typically offer different interest rates depending on the size of the deposit.
How are Savings Interest Rates Calculated?
Banks advertise the said rate on an Annual basis, calculate it on a daily-basis, and pay it on a quarterly-basis.
Ok, what the hell does that mean?
Say you have INR20,00,000 in a HDFC savings bank account. Now, as per their website, their advertised savings interest rate is roughly 4%.
Your daily closing balance would of course be a moving figure, depending on ongoing deposits and withdrawals. However, for sake of easier calculation I make a simplifying assumption that your deposit balance of INR20,00,000 will stay the same for the next quarter (i.e. no withdrawals or deposits). See below how the bank will calculate the pay out the interest in that case:
Your daily interest rate:
=> Annual interest rate ÷ Number of days in a year
=> 4%÷365 = 0.01096%
Your daily interest amount*:
=> Daily Closing Balance × Daily interest rate
=> 20,00,000 × 0.01096%
Interest paid in the quarter**:
=> Daily interest amount × Number of days in a quarter
=> 219 × (365 ÷ 4)
*As mentioned earlier, in real life the daily closing balance changes each day based on ongoing deposits and withdrawals. In that scenario the daily interest rate of 0.01096% would be applied on the floating daily closing balance each day to calculate the daily interest amount.
**Calculated daily interest amounts would be added over a 3 month period to calculate the interest paid in the quarter.
Closing Balance = Opening Balance + Interest credited + Other credits - Debits
= 20,00,000 + 20,000 + 0 – 0
It is evident why the bank advertises its saving interest rate on an Annual basis – because 4% annually looks much better than 0.01096% daily
Next quarter’s interest will be calculated on closing balance for this quarter (i.e. INR20,20,000) – the power of compounding at work!
2. Fixed Deposits
A fixed deposit is like a savings account, but with the expectation that you will not withdraw your funds for a fixed amount of time (often termed as “maturity”, “tenor”, or “period”).
Banks in general offer both “withdrawable” and “non-withdrawable” facilities, the former where you can withdraw funds before your period expires by paying a penalty, and the latter where the bank will plough back the interest payments paid to-date before they unlock your deposit.
The interest rates would increase as the period of your fixed deposit product increases.
As seen above, savings accounts and fixed deposits comprise fairly simple applications of interest rates. The rates offered are typically standardised and credit risk does not play much of role, considering the borrowing counter-party is the bank itself.
Next week I will review interest rates within lending products where things get more complicated. Afterall, the borrowing counter-party in that case would be you.
To warm up, I would first look at the beloved and handy Car Loan. Stay tuned.