Chapter 2

# What Is Interest Rate And How Does It Work?

Interest rates are usually expressed as a percentage of a principal amount. It can be fixed or variable, depending on the bank. Interest rates work in two ways for the average consumer:

- It’s the cost of borrowing money
- The amount of money yielded by an investment or a deposit account

Interest rates differ, depending on the type of instruments (e.g. traditional deposit instruments like savings deposit, time deposit, and some demand or current accounts, and investment instruments like bonds and securities) and on the tenure of investment.

**How do banks determine interest rates? **

Today, the level of interest rates is determined by the interaction of the supply and demand for funds in the money market. Interest rates, prior to their full liberalization in 1983, were fixed by the Bangko Sentral ng Pilipinas (BSP). In 1981, the then Central Bank of the Philippines deregulated all bank rates except short-term lending rates. In 1983, the deregulation of bank rates was completed with the removal of the remaining ceilings on short-term lending rates.

**How are interest rates regulated?**

Interest rates in the Philippines follow a market-oriented structure, where any financial institution offering banking products and services can set their own rate. This means BSP does not regulate the interest rate charged by banks, lending investors, and pawnshops.

However, for transparency purposes, the BSP requires that the interest rates applied must be duly indicated – on the pawn ticket in case of pawnshops, the promissory note in the case of lending investors, and loan agreements in the case of bank loans. The Monetary Board only sets rates for the BSP’s overnight borrowing and lending facility to influence the timing, cost and availability of money and credit, for the purpose of stabilizing the price level.

**What causes interest rates to rise and fall?**

Interest rate movements in the Philippines are affected generally by the price level or inflation rate, fiscal policy stance, and intermediation cost which could impact the demand and supply for money.

**1. Inflation rate**

One of the BSP’s mandate is to maintain price stability, which in turn will influence the interest rate level.

**How does this affect the interest rate?**

When there is too much liquidity in the system, there is more pressure for inflation to rise. To curb inflationary pressures arising from excess liquidity in the system, the BSP will have to increase its key policy rates, sending a signal to the market that the general level of interest rates will be on an upward trend. Bank lending rates simply mirror the BSP’s policy rate movements.

**2. Fiscal policy stance
A government that incurs a fiscal deficit needs to finance its existing budgetary requirements by borrowing from the domestic market or from abroad. **

**How does this affect the interest rate?**

The higher the fiscal deficit is, the stronger the demand to borrow to finance the gap. This exerts upward pressure on domestic interest rates, particularly if the government borrows from a relatively less liquid domestic market.

**3. Intermediation cost
This is the cost to match lenders to prospective borrowers. Financial institutions incur costs in extending their services as an intermediary. Interest rates will tend to be high when this cost is high. Included in the intermediation costs are administrative costs and the BSP’s reserve requirements.**

**Four types of interest rates**

Banks and financial institutions impose different types of interest rates appropriate to their financial services. In an attempt at good faith to provide a fairer fee for financial services, there are different means to derive an interest rate!

**1. Nominal interest**

Nominal interest rates are also known as the fixed interest rate. This does not take inflation into account. It is the interest rate that is quoted on most commercial banks’ products such as loans. This type of interest rate follows a simple concept: if you borrow ₱1,000 at a 5% interest rate, you are expected to pay ₱50 in interest without taking inflation into account.

*How to compute?***Interest ** = principal amount x interest rate / tenure

**Monthly repayment** = principal amount / tenure + monthly interest

**Loan amount**: ₱100,000

**Tenure:** 12 months

**Interest rate:** 10%

=₱100,000 x 10%

=₱10,000

=₱10,000/ 12 months

**₱833.33 – Monthly interest**

**=₱100,000/ 12 **

**= ₱8,333.33**

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**=₱8,333.33 + ₱833.33 **

**= ₱9,166.66 – Total monthly repayment with interest**

**2. Effective interest rate**

This is the interest rate that is earned or paid on an investment, loan or other financial product due to the result of compounding over a given time period. Effective interest is calculated by taking the nominal interest rate and adjusting it to the number of compounding periods (number of months repayment).

**How to compute?**

Loan amount: ₱100,000

Term – 12 months

Interest rate – 10%

**1st month repayment**

Principal repayment | Loan principal / tenure (in months) |

₱100,000 / 12 months = ₱8,333.333 | |

1st month interest | Loan principal x interest rate / tenure (in months) |

₱100,000 x 10% / 12 months = ₱833.33 | |

Total 1st month repayment (principal repayment + 1st month interest) | ₱9,166.66 |

Remaining loan amount | = ₱100,000 - ₱9,166.66= ₱90,833.34 |

**2nd-month repayment**

Principal repayment | Loan principal left / tenure (in months) |

₱90,833.34 / 12 months = ₱7,569.445 | |

2nd month interest | Loan principal left x interest rate / tenure (in months) |

₱90,833.34 x 10% / 12 months = ₱756.9 | |

Total 2nd month repayment (principal repayment + 2nd month interest) | ₱8,326.38 |

Remaining loan amount | = ₱90,833.34 - ₱8,326.38= ₱82,506.96 |

*The monthly repayment will be different every month, and it will be lower compared to the previous months. As the principal amount goes down, so does the interest until the tenure is completed. *

**3. Floating**

This type of interest rate is also known as the adjustable or variable rate. It does not have a fixed rate for the interest it imposes on a product, instead, its interest rates will be based on a benchmark (consumer price index – CPI) such as the forex or the Philippine Stock Exchange.

For this type of interest, there are options that can hedge the floating-rate loan. There are some options that come with an interest rate cap that ensures a borrower’s future interest cash flow will not be exceeding a certain predefined level.

CPI + interest rate

Loan amount: ₱100,000

Term payment- Every 6 months for 2 years

interest rate – 3.5% per month

Initial CPI – 2.5%

Sample interest rates computation |
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Tenure | CPI rate + interest rate | Interest amount |

1st month to 6th month ↔ | 2.5% + 3.5% = 6% | ₱6,000 |

6th to 12th month ↑ 1% CPI | 3.5% + 3.5% = 7% | ₱7,000 |

12th to 18th month ↓0.5% | 3% + 3.5% = 6.5% | ₱6,500 |

18th to 24th month ↑1% | 4% + 3.5% = 7.5% | ₱7,500 |

A customer borrows ₱100,000 from a bank; the terms of the loan are (six-month) CPI+ 3.5%. At the time of issuing the loan, the CPI rate is 2.5%. For the first six months, the borrower pays the bank 6% annual interest: in this simplified case ₱6,000 for six months. At the end of the first six months, the CPI rate has risen to 4%; the client will pay 7.5% (or ₱7,500) for the second half of the year. At the beginning of the second year, the CPI rate has now fallen to 1.5%, and the borrowing costs are ₱6,000 for the following six months.

**4. Flat rate**

This interest rate is the simplest to understand. Unlike a fixed rate where the interest rate is solely based on a percentage of the loan amount, flat rate, on the other hand, is simply a predefined charge or fee on top of the product’s amount. It is simply a pricing structure that charges a single fixed fee for a service, regardless of usage. Less commonly, the interest rate will not depend on the length of time or tenure of the loan or service.

For example, your loan amount is ₱100,000 and the financial institution’s policy states that they charge a processing fee of ₱2,500 for their service. Your total due will only be ₱102,500 and the tenure will not be affected by the fee and vice versa.

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