Origin of the banking and financial system is full of tales. Financial contracts are reported to be as old as written language. Economic historians sum up an interesting piece of observation that writing appears to have been invented for the purposes of recording financial deals.
Where did the idea of borrowing and lending come from? How did the idea of interest payments evolve? These are a few interesting questions.
Basically, the concept of every aspect of the financial system has its own story. Even as implementation of the concepts has undergone a sea change, the basic architecture of the functions of the financial system, to be precise, the banking system is intact even today. If Deposits and Loans form the pillars of this financial architecture, it is the Rate of Interest (RoI) which is life line not only of the banking system but of the whole growth process taking place in the overall economic cycle. Remove this RoI component from the system, you won’t find depositors. Thus, leaving no scope to lend, which means money won’t multiply.
So, it’s the Rate of Interest that drives the flow of money from individual to individual, sector to sector and place to place. Ultimately, it results in the economic development of communities and societies.
Before understanding the origin and concept of Rate of Interest, it makes sense to have a snapshot of the story of incipient human activities.
According to an essay originally created for the Swiss Money Museum website in mid 1999 and inputs from Stephen Zarlenga’s book -The Lost Science of Money – ‘from about 30,000 BC human existence became more refined until social and economic forms of agriculture appeared around 10,000 to 7,500 BC. This took the form of hoe gardening done mainly by women and led to matriarchal based societies. From around 6,000 BC the horse was tamed and sheep, goats and cattle were domesticated so that by 5,000 there existed a mixed culture based on animal breeding and hoe gardening. The great plough revolution starting about 4,500 was complete by 4,000 BC, enabling the first city civilizations to arise, and the introduction of writing shortly after, led to a developing social technology’.
Loans in the pre-urban societies were made in seed grains, animals and tools to farmers. Since one grain of seed could generate a plant with over 100 new grain seeds, after the harvest farmers could easily repay the grain with “interest” in grain. Also since just so much seed grain could possibly be used, there were natural limits to this lending activity. When animals were loaned interest was paid by sharing in any new animals born. What was loaned had the power of generation, and interest was a sharing of the result. Interest on tool loans would be paid in the product which the tools had helped to create.
In his Ancient Economic History, for instance, Heichelheim, a German-born ancient historian, who specialized in ancient economic history, believed that this kind of lending occurred as early as the neolithic age, with early “food-money” and credit being linked by about 5000 BC: “Dates, olives, figs, nuts, or seeds of grain were probably lent out . . . to serfs, poorer farmers, and dependents, to be sown and planted, and naturally an increased portion of the harvest had to be returned in kind.” In addition to fruits and seeds, “animals could be borrowed too for a fixed time limit, the loan being repaid according to a fixed percentage from the young animals born subsequently.”
Today, basic principles of the Interest component remain the same. However, its implementation and methodology has undergone a sea change. Banks and financial institutions are engaged in an interest rate war to woo more and more business through depositors as well as borrowers.
What are the main Interest options available to borrowers?
It is imperative for individuals and organizations to understand different aspects of rate of interest & their impact on them, especially at a time when they are borrowing money from banks and financial institutions. Bank branches remain flooded with customers seeking access to loans to negotiate their various needs. And, of course, liberal loaning has revolutionized businesses and peoples’ lives.
However, it has been observed that in a rush for obtaining a loan, the borrowers don’t evince any interest in understanding different aspects of a loan process. Mostly, they don’t work out the cost of their loan – the rate of interest and its application on the loan amount.
Usually there are two options to charge interest on loans – fixed rate and floating rate option. In fixed rate options, usually the interest rate is fixed for the entire period of the loan. It’s not linked to the market conditions and remains stagnant throughout the currency of the loan. However, this fixed rate option too can change.
In the case of a floating rate loan, the interest rate is not fixed. It is linked to the MCLR (Marginal Cost-based Lending Rates). Marginal Cost of Funds based Lending Rate is the minimum lending rate below which a bank is not permitted to lend. Presently, the banks in line with the RBI directions are using the Repo Rate Linked Lending Rate (RLLR). Under the RLLR model, any change in the repo rate has a direct impact on the interest rates.
For example, if the RLLR is hiked, the interest rate on the loans will also go up and subsequently EMI will also go up. However, if the RLLR goes down, the interest rate on the loans will also go down. The bank fixes a spread between BR and floating rate while sanctioning a loan.
Precisely, the floating rate option means that the rate of interest on the loan will fluctuate, up or down, depending on the market condition.
Despite opting for a fixed rate of interest, banks still reset the rate of interest during the currency of the loan. Is it justified?
It’s very important to understand that banks include a reset clause in the loan agreement in which the borrower authorizes the bank ‘to reset the fixed rate whenever deemed fit by the bank’. Mostly, the borrowers are unaware of this reset clause of the fixed rate option. When the bank invokes this clause after a few years, the borrowers call it ‘cheating’ by the bank, which actually it is not.
It has been commonly observed that most of the borrowers have a habit not to go through the loan agreement documents before signing it. They only come to know about terms and conditions when the banks enforce them.
Meanwhile, as per the Code of Bank’s Commitment to Customers, it’s obligatory on part of banks to inform the customers of any change in interest rate. It is the right of the customer to ask the bank to give a copy of the revised repayment schedule of the loan every time the interest rate in his loans is revised.
What is the methodology of applying the rate of interest on loans?
The most important part in a loan is the interest rate at which you shall be getting the loan facility. This is your cost of loan. You as a borrower should understand the methodology of applying interest on your loan amount. Two common methods are used for calculating interest on loans – flat interest rate method and reducing balance interest rate method.
Flat rate method is the percentage of interest charged on the initial loan amount (principal amount) during the currency of the loan. Here the amount repaid in equated monthly installments is not considered while calculating the interest. Precisely, you have to pay interest on the entire loan amount (principal) throughout the loan tenure.
Even as flat interest rates are generally lower than the reducing balance rate, actually these rates range from 1.7 to 1.9 times more when converted into the effective interest rate equivalent.
As far as reducing the balance interest rate method is concerned, it doesn’t conceal any further percentage of interest. Under this method, interest is calculated every month on the outstanding loan amount. In this method, the equated monthly installment includes interest payable for the outstanding loan amount for the month in addition to the principal repayment. The interest for the next month is calculated only on the reduced balance or outstanding loan amount.
So, be alert. Always check methodology of interest application. Lowest rate doesn’t necessarily mean low cost loan; it could be the most expensive deal.
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