When a person borrows some money from another person, this money comes at an interest which can also be called the "Opportunity Cost" of the money. The amount lent is called the "Principal" and the interest on the "Principal" is in annualized terms.
The interest rates are affected by the demand and supply of money. So, if at any point of time, if the demand for money is higher, its interest rates will increase and if the demand for money is lower, interest rates will fall.
Theoretically the interest rates should reach equilibrium, when demand and supply coincide.
But practically it does not happen.
This is because RBI influences the interest rates by increasing and decreasing the liquidity in the system. This is one factor. The factors which affect the interest rates are as follows:
RBI's Monetary Policy: The objective of RBI's monetary policy is the price stability and economic growth. RBI when loosens the monetary policy (i.e. decreases the repo and reverse repo) , the money supply in the system expands, and the interest rates come down. If the RBI tightens the monetary policy, the money supply in the system contracts and the interest rates tend to go high.
Economic Growth: When economy of the country is on growth path. The demand for money Increases. So there is an upward pressure on the interest rates.
Inflation: The rise in the general price level of the Goods and services is Inflation. In a situation of Inflation, too much money chases too few goods. So the purchasing power of each unit of currency decreases. The adverse impact of the higher inflation is that people want safer returns on their lending against the inflationary trends. This makes the interest rates go up.
Global Trends: A favorable global liquidity atmosphere helps the domestic atmosphere to be favorable.
The interest rates affect both the borrowers and lenders. Interest rates get a very important role in making the Government Policies. The interest rates affect the investment and saving behavior of the individuals, companies and Banks.
The interest rates can be simple, where interest is not added in the principal or it can be compound, where interest is added to the Principal.
Governments ask the financial institutions to disclose their interest rates as yearly compound interest rates on deposits and advances. Many terms are used for these annual compound rates which all have the same meaning. Some of them are Annual Percentage Rate (APR), Annual Equivalent Rate (AER), Annual Percentage Yield (AEY) , Effective Interest Rate, Effective Annual Rate etc.
Apart from that we have two more terms associated with the interested rates viz. Fixed and Floating.
Fixed rate is fixed at the time when a loan is given and remains constant for the entire loan tenure. Floating rate keeps fluctuating. Some reference rates such as Base Rate, Prime lending rates are the rates on which the loans are linked. It can be like PLR-1 or PLR -2 or anything like that.
A few days back, the banks were free to decide their prime lending rates (PLR) which served as the benchmarks for most of bank lending. However, with RBI asking them to move to the Base Rate, the PLR has been replaced with the Base Rate system. The Base rate formula is linked to the cost of deposits for every bank. The Base Rate would be transmitting the changes in the monetary policy more effectively as any drop in the cost of borrowing for banks will result in lower lending rates