How interest rates work
What an interest rate pays for, why there are so many, and how RBI's rate reaches a deposit, a loan and a bond
Market yields as on 1 September 2026; policy rate as on 7 October 2026
Verified 12 October 2026
For training and education only. Not investment advice.
Trainer notes
Ask the room to call out every interest rate they have met this month: savings account, fixed deposit, home loan, credit card, a bond yield in the news. Write them up. The deck explains why the list has so many different numbers on it.
An interest rate is the price of using someone else's money for a period of time.
The borrower pays to spend now. The lender is paid for waiting and for the risk taken. There are many rates because there are many borrowers, periods and risks.
Trainer notes
Stay on the word 'price'. Like any price it is agreed between two sides, and it differs with what is being bought: whose promise, for how long, and how sure the repayment is.
What a lender is paid for
Waiting
The lender gives up the use of the money for a period. Interest is the payment for that wait.
Rising prices
Money repaid later buys less if prices have risen. Lenders ask for a rate that covers the inflation they expect.
Risk of loss
A borrower may not repay in full or on time. The weaker the ability to repay, the higher the rate a lender asks.
Being locked in
Money tied up for long, or hard to get back early, usually earns more than money available on demand.
Take-away: Each interest rate is a mix of these four payments. Change the borrower or the period and the mix shifts.
Trainer notes
Test it on the list from the opening. A savings account pays little because the money is available on demand. An unsecured loan usually carries a higher rate than a loan backed by a house because the lender has less to fall back on. 'Usually' matters: these are tendencies, not rules.
Nominal rate and real rate
THE SET-UP
A saver puts ₹1,00,000 in a one-year deposit at 7%.
Over the same year, prices rise 5%.
Both figures are assumed.
- After one year the deposit is worth ₹1,00,000 × 1.07 = ₹1,07,000. The 7% is the nominal rate: the rate in rupees.
- Goods that cost ₹1,00,000 a year ago now cost ₹1,00,000 × 1.05 = ₹1,05,000.
- What the saver can buy has grown by 1,07,000 ÷ 1,05,000 = 1.0190, that is 1.90%. This is the real rate.
- The shortcut is nominal minus inflation: 7% − 5% = 2%. It is close, and it slightly overstates the exact answer.
Result: Nominal 7%, inflation 5%, real 1.90%. The real rate is what the saver gains in buying power.
Illustration with assumed figures. Not a forecast and not an indication of any deposit rate. Tax is ignored.
Trainer notes
Do the division with the room. Tax on the interest would reduce the real gain further; leave the amount out, because it depends on the saver. A real rate can be negative when inflation is above the nominal rate. The same arithmetic works for a borrower: inflation reduces the real burden of a fixed repayment.
Same borrower, longer period, higher rate
| Yield (%) | |
|---|---|
| 91 days | 5.26 |
| 182 days | 5.62 |
| 364 days | 5.80 |
| 2029 | 6.44 |
| 2031 | 6.58 |
| 2036 | 6.96 |
| 2041 | 7.11 |
| 2055 | 7.55 |
Read the chart
- One borrower throughout: the Government of India. Only the period changes.
- A 91-day Treasury bill yields 5.26%. A bond that matures in 2055 yields 7.55%.
- Lenders are paid more for a longer wait and for more years of uncertain inflation.
- This upward slope is the usual shape. It is not a rule.
Source: RBI Current Rates as on 1 Sep 2026. Treasury bills (91, 182, 364 days): cut-off yield at the auction of 27 Aug 2026. Bonds maturing 2029 to 2055: yields on 1 Sep 2026.
Trainer notes
The first three points are Treasury bills; the next five are dated government bonds, labelled by the year they mature (6.20% GS 2029, 6.36% GS 2031, 6.94% GS 2036, 7.06% GS 2041, 7.24% GS 2055). The line is called the yield curve. It can be flat, or slope downwards, when lenders expect rates to fall. The axis starts at 5.0, so the slope looks steeper than it is. The points are not evenly spaced in time. Market figures are shown with a lag of at least 30 days, in line with SEBI's norms on price data used for education.
From the repo rate to your rate
RBI's policy repo rate is 5.50%. Each rate below follows it in its own way and at its own speed.
| Rate | How the policy rate reaches it |
|---|---|
| Money market rates | Overnight and other short-term rates move almost at once. The deck 'RBI's toolkit' shows the corridor that holds them. |
| Deposit rates | Banks reset the rates they offer on new deposits. A fixed deposit already made keeps its contracted rate until it matures. |
| Loans on an external benchmark | Floating-rate retail loans and loans to micro, small and medium enterprises. Reset at least once in three months. |
| Loans on MCLR | Loans priced from 1 April 2016 on the bank's own cost of funds. Reset on the loan's reset date, at least once a year. |
| Bond yields | Short-term yields tend to move with the repo rate. Longer yields also weigh expected inflation and government borrowing. |
Sources: RBI Monetary Policy Statement, 7 Oct 2026; RBI (Commercial Banks – Interest Rates on Advances) Directions, 28 Nov 2025; RBI MCLR release, 17 Dec 2015.
Trainer notes
The external benchmark can be the repo rate, a Treasury bill yield or another published market benchmark. The bank adds a spread that it decides. MCLR is the marginal cost of funds based lending rate, a benchmark each bank computes from its own costs. Loans older than April 2016 may still be on the Base Rate. Fixed-rate loans do not move at all.
A 125 basis point cut: what arrived
| Fall (basis points) | |
|---|---|
| Repo rate | 125 |
| New loans | 80 |
| Existing loans | 91 |
| New deposits | 63 |
| Existing deposits | 51 |
Read the chart
- RBI cut the repo rate by 125 basis points between February and December 2025. 100 basis points is 1 percentage point.
- By June 2026 banks' average rate was down 80 basis points on new loans and 91 on existing loans.
- Average term deposit rates were down 63 basis points on new deposits and 51 on existing ones.
Source: RBI Governor's Statement, 5 Aug 2026, footnote on transmission. Scheduled commercial banks; weighted average rates on rupee loans and domestic term deposits.
Trainer notes
The point is that the pass-through is partial and takes time, and that it differs between loans and deposits. These are averages across all banks and all loans, so the mix of lending also moves them. RBI raised the repo rate by 25 basis points on 7 October 2026; that change is not in this chart.
Where rates stand
Four rates, four numbers: borrower, period and date all differ. Check the date before you quote them.
- RBI POLICY REPO RATE
- 5.50%Overnight money for banks. Raised from 5.25% on 7 October 2026.
- 364-DAY TREASURY BILL
- 5.80%The Government borrowing for a year. Cut-off yield, auction of 27 August 2026.
- BOND MATURING 2036
- 6.96%The Government borrowing to 2036. Yield on 6.94% GS 2036, 1 September 2026.
- NEW BANK LOANS, AVERAGE
- 8.61%Banks' average rate on fresh rupee loans in August 2026.
Sources: RBI Monetary Policy Statement, 7 Oct 2026; RBI Current Rates as on 1 Sep 2026; RBI, Lending and Deposit Rates of Scheduled Commercial Banks, 30 Sep 2026.
Trainer notes
On the deposit side, the same RBI release puts banks' average rate on fresh rupee term deposits at 5.67% in August 2026. Refresh these at each month-end, using market figures that are at least 30 days old. Do not comment on where rates will go next. Market figures are shown with a lag of at least 30 days, in line with SEBI's norms on price data used for education.
Who feels a change in rates
When rates rise
- New deposits and new bonds pay more.
- Floating-rate borrowers pay more: the EMI rises or the loan runs longer.
- Bonds already issued fall in price. Debt fund NAVs carry that fall.
- New borrowing costs businesses more.
When rates fall
- New deposits and new bonds pay less.
- Floating-rate borrowers pay less: the EMI falls or the loan ends sooner.
- Bonds already issued rise in price. Debt fund NAVs carry that rise.
- New borrowing costs businesses less.
Take-away: Fixed-rate deposits and loans keep their contracted rate. This slide describes effects; it is not advice.
Trainer notes
Most households are both savers and borrowers, so the net effect differs from one family to the next. Whether a bank changes the EMI or the tenure depends on the loan terms. The bond price effect is explained in the deck 'Bond prices and yields'. We describe these effects; we do not tell a client what to do because of a rate change.
If you learnt this from older material
What older decks say
- Banks price loans off their Base Rate or prime lending rate.
- A rate cut reaches a borrower when the bank chooses to change its own benchmark.
- The reverse repo rate is the floor for overnight rates.
What holds now
- MCLR replaced the Base Rate for new loans from 1 April 2016.
- New floating-rate retail loans follow an external benchmark, since 1 October 2019.
- The floor is the Standing Deposit Facility rate, since April 2022.
Take-away: At end-June 2026, 68.2% of banks' floating-rate rupee loans were on an external benchmark.
Sources: RBI press release of 17 Dec 2015 (MCLR); RBI circular of 4 Sep 2019 and Directions of 28 Nov 2025; RBI, Lending and Deposit Rates of SCBs, 30 Sep 2026.
Trainer notes
The same RBI release puts MCLR-linked loans at 29.6% of floating-rate rupee loans at end-June 2026. The release does not break down the remaining 2.2%. The Base Rate itself dates from 1 July 2010. Existing borrowers on older benchmarks were given the option to move to the newer one on terms agreed with the bank.
Four things people get wrong
Misconception'RBI sets the rate on my loan.'
What is trueRBI sets the repo rate. The bank sets the loan rate: a benchmark plus a spread that the bank decides.
Misconception'A 7% deposit grows my money by 7%.'
What is trueIn rupees, yes. In buying power the gain is the real rate. With prices rising 5%, that is 1.90% before tax.
Misconception'Repo is cut, so my deposit pays less.'
What is trueA fixed deposit already made keeps its rate until maturity. New deposits and renewals get the new rates.
Misconception'Longer loans always carry higher rates.'
What is trueUsually, not always. When lenders expect rates to fall, long-term rates can sit level with or below short-term rates.
Trainer notes
On the first point: under RBI's 2019 rules a bank is free to decide the spread over the external benchmark, and the part of the spread that reflects the borrower's credit risk changes only if the borrower's credit assessment changes substantially. On the third: some banks offer floating-rate deposits, which do move.
Check yourself
Question 1: A deposit pays 8% a year and prices rise 6% over the year. What is the real rate, by the shortcut and exactly?
Answer: Shortcut: 8% − 6% = 2%. Exact: 1.08 ÷ 1.06 = 1.0189, so 1.89%. The shortcut slightly overstates it.Question 2: A home loan is linked to the repo rate. RBI raised the repo rate on 7 October 2026. How soon must the loan rate reflect it?
Answer: At the loan's next reset. On an external benchmark the reset must come at least once in three months; a bank may reset sooner. The bank's terms decide whether the EMI or the tenure changes.Question 3: As shown by RBI on 1 September 2026, a 91-day Treasury bill yielded 5.26% and a bond maturing in 2036 yielded 6.96%. Give two reasons for the gap.
Answer: The lender waits longer, and faces more years of uncertain inflation and interest rates. The borrower and the credit risk are the same in both cases.
Sources and disclaimer
Sources for the figures in this explainer
- Repo rate 5.50%, raised from 5.25%: RBI Monetary Policy Statement, Press Release 2026-2027/1264, 7 Oct 2026.
- Treasury bill and government bond yields: RBI Current Rates as on 1 Sep 2026, page archived 2 Sep 2026 (Treasury bills at the 27 Aug 2026 auction cut-off).
- Average loan and deposit rates, August 2026; external benchmark and MCLR shares, end-June 2026: RBI Press Release 2026-2027/1224, 30 Sep 2026.
- Fall in lending and deposit rates, February 2025 to June 2026: RBI Governor's Statement, 5 Aug 2026.
- External benchmark, reset at least once in three months: RBI Interest Rates on Advances Directions, 28 Nov 2025 (first set 4 Sep 2019).
- MCLR from 1 Apr 2016, reset of one year or lower, Base Rate from 1 Jul 2010: RBI Press Release of 17 Dec 2015.
- Standing Deposit Facility as the floor since April 2022: RBI, Monetary Policy overview, rbi.org.in.
This material is for training and investor education only. It is not investment, tax or legal advice and is not a recommendation to buy, sell or hold any security or scheme. Examples use assumed figures unless a source and date are shown. Mutual fund investments are subject to market risks; read all scheme related documents carefully. Trustner Asset Services Pvt. Ltd. is an AMFI-registered Mutual Fund Distributor (ARN-286886).