Over the past couple of years, the concept of a personal loan has risen in popularity by leaps and bounds across the country. While this is not a novel concept to India, one of the main proponents of this is the increase in the number of lenders who can now leverage modern technology to serve customers personal loans of their choice.
However, although the process of applying and subsequently getting approved for a personal loan has become easier over the years, one question which still ponders the mind of many is how the interest on a personal loan is calculated?
Thus, in today’s blog post, we will try to understand in detail how lenders across India calculate interest payments on personal loans.
Without further ado, let’s get started.
Interest Rates – A Rundown
One of the first and most important aspects we need to understand is the concept of interest rates and the various types of interest rates available in India.
In simple terms, an interest payment can be understood as a fee you pay on a monthly or yearly basis on the loan amount you have borrowed from the lender. It can be understood as the charge the lender levies on you for letting you avail the convenience of a personal loan.
Interest rate systems are prevalent across every type of lending and credit instrument available; however, their rates tend to vary depending on the customer profile as well as the lender.
For instance, interest rates on personal loans in India vary between 12% to 26% per annum, while for home loans, it generally ranges between 6.5% to 18% per annum.
Now, while superficially it might appear that the interest calculation of all these loans are similar, there is more to this than meets the eye. At its essence, there are three different systems of interest calculation widely followed by lenders.
- Fixed-rate of interest
- Variable or floating rate of interest
- Reducing balance rate of interest
Let us understand each of them in detail.
- Fixed-Rate of Interest
As the name suggests, a fixed rate of interest system is one where the rate of interest being charged on the loan remains consistent throughout the tenure of the loan. Undoubtedly, one of the most popular forms across both lenders as well as borrowers, a fixed interest rate system is easy to comprehend and guarantees a steady repayment for both the stakeholders.
The common methodology followed by lenders when deciding on a fixed interest rate system is one where both the stakeholders sign a document which outlines the interest rate being charged, and the same document specifies that the same will remain consistent throughout the tenure of the loan, irrespective of external factors.
- Floating Rate of Interest
The next system, after a fixed rate of interest, is a floating rate of interest. While this is not as popular as a fixed interest rate system, in some situations, it is employed by lenders to arrive at a mutually acceptable repayment plan. In India, the RBI or the Reserve Bank of India periodically defines a repo rate, which can simply be understood as the rate of interest the RBI charges on amounts it lends to commercial banking institutions.
The floating interest rate system is conceived around the same. Alternatively known as the RLLR or the Repo Linked Lending Rate, this interest rate is marginally above the repo rate and changes from time to time depending on the notification received from the RBI.
While it is true that in some cases, the RLLR will be less than the fixed rate of interest being charged by the lender, the alternative truth, that it can increase when the repo rate increases, also needs to be acknowledged.
Thus, to summarize, a floating interest rate system is one where the interest rate being charged is linked to the RBI repo rate, and thus it can change from time to time depending on market conditions.
- Reducing Balance Interest Rate
Last but not least is the reducing balance interest rate system. Most commonly found in consumer loans such as vehicle loans, it essentially translates to the fact that you will only be charged interest on the remaining loan amount you owe and not the actual principal amount.
Simply put, a reducing balance interest rate translates to the fact that your EMI obligations will continue to decrease every month as you start repaying your EMIs.
In most cases, employing a reducing balance interest system benefits the borrower; however, in rare instances, it can be more expensive than a fixed interest rate system. So make sure you consider your options carefully before choosing.
How Is Your Interest Calculated?
Now that you understand the essence of interest rates and the various systems of interest rates available in India, the next step is to understand the calculation.
In most cases, lenders follow the universal EMI calculation formula as shared below.
EMI = P × r × (1 + r)n/((1 + r)n – 1)
In the above formula,
- P indicates the principal amount
- R indicates the rate of interest being charged on the loan, and
- N indicates the total tenure of the loan to be calculated in months
As the name indicates, EMI stands for Equated Monthly Installments, and thus the total tenure of the loan always needs to be captured in months rather than years.
At first glance, understanding how lenders calculate the interest payments on your loans can be difficult. However, as we shared in this article; once you figure out the type of interest rate being charged on your loan, all you need to do is place it in the EMI formula, and you can arrive at both the total interest amount being charged, along with the EMI amount you owe to the lender.