Interest rates

In simple terms

An interest rate is the price of money. A borrower pays it for the use of someone else's money; a saver or lender earns it for giving up the use of their own. Like any price, it reflects supply and demand, the risk of not being repaid, expected inflation, and the policy of the central bank.

Interest rates reach almost everything: home loans, deposits, company borrowing, government debt, and the value investors put on shares.

Nominal and real rates

The nominal rate is the rate quoted. The real rate adjusts for inflation, showing the gain in buying power, as the nominal and real returns lesson explains.

When inflation is higher than the deposit rate, the real rate is negative: savers lose buying power even though their balance grows.

How banks set rates

A bank's lending rate is roughly built from:

1. Its cost of funds: what it pays depositors and other lenders.
2. Its own costs of running the business.
3. A margin for profit.
4. A premium for credit risk: riskier borrowers pay more.

The RBI's policy rate influences the cost of funds, directly for loans linked to it and gradually for others, as the RBI monetary policy lesson explains. Longer-term rates, such as those on bonds, also reflect expected future rates and inflation, as the bond yields lesson explains.

How rates affect companies

Interest costs. A company with debt pays more when rates rise.

Demand. Higher rates make loans for homes, cars and machinery more expensive, slowing spending in rate-sensitive industries.

Valuation. A share's value rests on future profits, discounted at a rate that includes the return available on safer investments. When rates rise, future profits are worth less today.

Companies whose profits lie mostly far in the future, such as fast-growing ones, are usually the most sensitive, as the discounted cash flow lesson explains.

Why lower rates are not always good news

Rate cuts lower borrowing costs and raise valuations, all else equal. But all else is rarely equal:

• Rates are often cut because the economy is weakening, which hurts profits.
• Banks can earn thinner margins when rates fall, depending on how quickly loan and deposit rates adjust.
• Savers who live on interest income lose.
• Markets react to cuts compared with expectations: a cut that was fully expected may move prices little, as the expectations and surprises lesson explains.

Why it matters

Interest rates link the economy to every investment. They change what companies pay, what customers can afford, what savers earn and what investors will pay for future profits. Understanding the links helps explain why markets watch inflation and central bank decisions so closely.

Limitations

The examples isolate one effect at a time. In reality, rates, inflation, growth and expectations move together, and the overall effect on a company or the market depends on all of them. Different companies have very different sensitivities.

Common mistakes

• Ignoring inflation when comparing interest rates.
• Assuming rate cuts always lift share prices.
• Forgetting that debt-heavy companies feel rate changes most.
• Treating the policy rate as the rate on every loan.

Try it yourself

1. Find the interest rate on a bank deposit and the latest CPI inflation rate, and calculate the real rate.
2. For a company you follow, find its debt and interest cost in the annual report, and estimate the effect of a 1-point rise in rates on its profit.
3. Use the formula value = payment ÷ required return to see how much a fixed payment's value changes when the required return moves from 8% to 9%.