Interest

Topic: Banking, Credit Creation and Monetary Policy · NCERT: Class 7, Ch 8 "Banks and the Magic of Finance"; Class 8, Ch 7 "Factors of Production"

Meaning

Interest is the price a borrower pays for using someone else's money, or the income a lender earns for lending it. It is usually stated as a percentage of the sum borrowed, called the principal.

• Simple interest: SI = P × r × n
• Compound interest: A = P(1 + r)ⁿ
• A = final amount
• P = principal
• r = rate per period, as a decimal
• n = number of periods

Interest is how savings turn into loans. Savers earn it, and borrowers pay it. It also decides a bank's income. In economics, interest is the reward paid to capital, one of the four factors of production.

Explanation

How interest works: two sides of one price

• Deposit rate: what a bank pays you for keeping money with it. You are lending to the bank.
• Lending rate: what a bank charges you when you take a loan.
• The bank pays a lower rate to depositors and charges a higher rate to borrowers. The gap is the interest rate spread (lending rate − deposit rate). It is a bank's main source of income.
• Worked example (spread):
• Anand deposits ₹200 at 2%, so he earns ₹4.
• The bank lends that ₹200 to Shreya at 5% and collects ₹10.

• The bank keeps ₹6. This pays salaries and running costs, covers loans that are not repaid, and gives the bank its profit.

• Factor income: land earns rent, labour earns wages, capital earns interest, and the entrepreneur earns profit.

Simple vs compound interest

• Simple interest: interest is paid only on the original principal.
• Compound interest: interest is also earned on interest from earlier periods. It grows slowly at first and very fast later.
• Worked example: ₹1,000 at 6% a year (Class 7)
• Year 1: ₹60 interest, so the total is ₹1,060.
• Year 2: 6% of ₹1,060 = ₹63.60, so the total is ₹1,123.60.
• Year 12: ₹1,000 × (1.06)¹² = ₹2,012.20, so the money has doubled.

• Under simple interest, the total after 12 years is only ₹1,000 + (₹60 × 12) = ₹1,720.

• Rule of 72: years to double ≈ 72 ÷ interest rate (in %).

• At 6%: 72 ÷ 6 = 12 years, which matches the example above.

• The rule also works per month. At 5% a month, a debt doubles in about 72 ÷ 5 ≈ 14.4 months.

• Ambalappuzha chessboard story: put 1 grain of rice on the first square and double it on each square after that.

• 16th square: 2¹⁵ = 32,768 grains.
• 32nd square: over 210 crore grains.
• Lesson: compounding helps savers, but it traps borrowers who cannot repay.

Interest on loans: EMIs and terms of credit

• The interest rate is one of the four terms of credit. The other three are collateral (an asset pledged to the lender), documentation and mode of repayment.
• EMI (equated monthly instalment, a fixed monthly repayment):

• Formula: EMI = P × r × (1 + r)ⁿ ÷ [(1 + r)ⁿ − 1]

• Worked example: Megha's home loan

• Loan: ₹5 lakh at 12% a year for 10 years.
• Monthly rate: r = 1% = 0.01. Number of months: n = 120.
• (1.01)¹²⁰ ≈ 3.300
• EMI ≈ ₹7,174 a month.
• Total repaid ≈ ₹8.61 lakh, so total interest ≈ ₹3.61 lakh. The interest is more than 70% of the amount borrowed.

What makes interest rates higher or lower

• Liquidity given up: a fixed deposit (FD) pays more than a savings account.
• The depositor cannot take the money out quickly.
• So the bank can lend it for longer and earn more.

• The bank shares part of that extra income as a higher rate.

• Risk and collateral: lenders charge more when repayment is less certain. This is especially true for informal lenders who lend to people with no collateral.

• Type of account: current accounts, used mainly by businesses, earn no interest.
• The RBI's policy rates and reserves:
• Repo rate cut:
  • Loan benchmarks fall.
  • Home and small-business loan rates come down.
• CRR cut (CRR, the Cash Reserve Ratio, is the share of deposits a bank must keep with the RBI):
  • The bank earns no interest on this balance.
  • A lower CRR means less idle money, so the bank's cost of funds falls.
  • This allows lower loan rates.

In India

• Deposit rates were controlled, then freed:
• The RBI fixed the savings bank rate at 3.5% a year from 1 March 2003 [4].
• The RBI's 2011 discussion paper argued for freeing this rate. It said this would speed up monetary policy transmission (RBI rate changes reaching depositors and borrowers faster) and push banks to design new deposit products [4].

• Rates on all other deposits had already been freed by then [4]. The savings rate was deregulated later in 2011. Now each bank sets its own deposit rates.

• Loan rates linked to an external benchmark (from 1 October 2019):

• New floating-rate retail loans (home, auto, etc.) and floating-rate loans to micro and small enterprises must be linked to an external benchmark, a rate the bank does not control [5]. A floating-rate loan is one whose rate can change during the life of the loan.
• Allowed benchmarks are the repo rate (the rate at which the RBI lends money to banks for a short time), the 3-month or 6-month Treasury Bill yield published by FBIL, or any other FBIL-published rate [5].
• The loan rate must be reset at least once every three months [5].
• The operating-cost part of the bank's spread can change only once in three years [5].

• Borrowers on older benchmarks (MCLR or base rate) can switch without prepayment charges [5].

• CRR and the cost of funds:

• Banks earn no interest on money kept as CRR [2].
• The CRR was cut from 4.5% to 4.0% in December 2024 [3].
• It then fell to 3.0% of NDTL from 29 November 2025 [2]. NDTL (net demand and time liabilities) is roughly the bank's total deposits and similar liabilities to the public.

• On ₹100 crore of NDTL, this frees ₹1 crore more (compared with a 4% CRR) to lend and earn interest.

• Formal vs informal interest (Sonpur village), for ₹10,000 borrowed for 1 year:

Lender	Rate	Cost
Moneylender	5% a month	₹6,000 (simple interest)
Trader	3% a month	₹3,600, plus a forced sale of the crop at a low price
Bank	8.5% a year	₹850

Don't confuse with

• Interest rate spread: interest is the price of money on one side, either the deposit rate or the lending rate. The spread is the gap between the lending rate and the deposit rate, and it is the bank's income.
• Simple vs compound interest: simple interest is paid on the principal only. Compound interest is also paid on past interest. ₹1,000 at 6% becomes ₹1,720 under simple interest but ₹2,012.20 under compound interest after 12 years.
• "5% a month" vs "60% a year": 60% is true only for simple interest. With monthly compounding, (1.05)¹² ≈ 1.796, so the real cost is about 79.6% a year.
• Credit (in an account): this means money coming into an account. It is not interest, and it is not a loan.

Prelims Hooks

• Compound interest: A = P(1 + r)ⁿ. Simple interest: SI = P × r × n.
• Rule of 72: at 6%, money doubles in 72 ÷ 6 = 12 years. At 5% a month, a debt doubles in about 14.4 months.
• Current accounts earn no interest. Fixed deposits pay more than savings accounts because the depositor gives up liquidity.
• The savings bank rate was fixed at 3.5% from 1 March 2003 until it was deregulated in 2011. Banks now set deposit rates themselves [4].
• External benchmark lending (from 1 Oct 2019): covers new floating-rate retail and MSE loans. It is linked to the repo rate, 3- or 6-month T-bill yields, or FBIL rates, and resets at least every 3 months [5].
• Trap: a moneylender's "5% a month" is 60% a year at simple interest but about 79.6% when compounded.

Mains Points

• Cost of credit and inclusive growth (GS-III):
• Informal lenders charge 36–60%+ a year and often add tied crop sales or unpaid labour. Bank credit in Sonpur costs 8.5% a year.
• High interest plus compounding creates debt traps, as with Swapna, who lost land after her crop failed.
• Poor households lack collateral and documents, so they are pushed to informal lenders.

• So cheaper formal credit needs collateral-free products and better credit information, not only more bank branches.

• Freeing deposit rates: efficiency vs small savers (GS-III):

• Deregulating the savings rate in 2011 aimed at faster transmission and new deposit products [4].

• The risks were unhealthy competition among banks and harm to rural savers and pensioners, who have little bargaining power [4].

• Faster transmission through external benchmarks:

• A repo rate cut reaches home and MSE borrowers within three months [5].
• But most bank deposits are at fixed rates. So when rates fall, banks' margins get squeezed.
• Borrowers also face rate increases just as quickly when the RBI raises rates.

Related concepts

• Deposits
• Savings account
• Current deposit account
• Fixed deposit
• Demand deposits
• Cheque
• Passbook
• Debit and credit
• Compound interest
• Interest rate spread

Read more

• How a bank works: deposits, interest, spread and terms of credit