The interest rate is a significant part of a bank loan. When you take a loan, you are supposed to pay the loan back with a certain amount of interest and the principal amount. The interest amount of the loan that needs to be paid is considered as it affects the total cost payable to the bank. Only after conceding the interest amount a person decides whether he can afford the loan or not.
Loans are the lifeline for people in India as it helps them to deal with major financial issues. However, taking loans has limitations because interests need to be paid along with the principal amount. Paying the interest is crucial as it is the source of income for the lender bank that uses it to manage the costs. There is a lot of confusion surrounding the steps used to calculate the interest and how appropriate they are. Keep reading to gain insightful information about this process.
If we look at it mathematically, then there are two ways that banks use to calculate the rate of interest on loans, namely Simple Interest, and Compound Interest.
- Simple Interest:- The formula for calculating Simple Interest is PRT/100, where P stands for Principal Amount, R stands for Rate of Interest, and T stands for Time provided in years.
- Compound Interest:- The formula used to calculate Compound Interest is [P × (1+R)^T] – P. In this formula also, P, R, and T stand for the Principal amount, Rate of interest, and Time respectively. This is not the end because numerous aspects affect the rate of interest.
Several factors are considered while calculating the interest rate by various loan providers.
- CIBIL Score:- This shows the worth of your credit. It is the repository of your credit information. So, if you have a high CIBIL Score and your credit history is clean, it will open your path for an easy loan.
- Loan Type:- There are numerous varieties of loans, and the rate of interest differs according to the type of loan you take. The interest rate is decided based on whether the loan you took is secured or unsecured.
- The Repayment Tenure:- The time after which you would pay the loan back also plays a critical role in deciding the loan’s interest rate. If the person taking the loan needs a long time to pay it back, he will pay more interest. It can be adjusted if you have good relations with the bank and are an old and regular customer.
- Bank Rate:- It is defined as the rate at which the Reserve Bank of India provides loans to other commercial banks. They lend money from 90 days to one year, and there is no collateral involvement. So, when RBI lends at a very high rate of interest, commercial banks also raise their rate of interest.
- Repo Rate:- Repo rate is the short form for repurchase rate. The purpose of the repo rate is to reduce the gap between customers’ demand to get loans and the supply left with the bank to lend them. On the contrary, it is a short-term loan that helps to maintain the liquidity of RBI in the market. The repo rate affects the rate of interest too.
There are two significant types of interest rates, namely Fixed Interest Rate and Floating Interest Rate.
- Fixed Interest Rate:- As the name suggests, the interest rate on a loan is initially fixed and does not deviate even though there are fluctuations in the global financial market. People usually prefer loans with fixed interest rates so that it does not affect their budget. Fixed Interest Rates are generally secure and do not put the person paying them in confusion or uncertain situations.
- Floating Interest Rate:- The floating interest rate keeps flowing and changing according to the scene of the market. There will be a fixed benchmark rate, and the final payment will include or exclude the margins. Floating Interest Rates might be risky if there is less knowledge about it.
- Inflation:- Inflation is the phenomenon that raises the interest rates of the provided loan. The reason behind this surge is that the purchasing power has declined and has reduced the value of money. So, when there is inflation, people demand a higher rate of interest for similar reasons, which takes the rate of interest to the top.
- Income:- Your income affects the rate of interest on the loans as well. If you have a high salary, then it is only evident that you will be paying a high rate of interest.
You can take any loan like a home loan, car loan, personal loan, unsecured debt, student loan, marriage loan, business loan, or title loan. The interest rate will highly depend on the type of loan you take. Because along with the factors mentioned above, the interest rate is also affected by the loan you take.
The interest rates for the bank loan are calculated based on these factors. If you have taken a loan with a fixed interest rate, you will be asked to pay a fixed interest rate, whereas the rate of interest might fluctuate according to market conditions if there is a floating interest rate. It is crucial to consider all the above aspects before taking a loan as they will affect the rate of interest to be paid with the principal amount of the loan.
The calculation of the rate of interest for loans is not very difficult to do at a lower level. But in the case of banks, it involves a lot of elements which makes the calculation a bit complex. They use the machine to do the maths. Still, before that, they see the type of loan, whether it has a fixed or floating interest rate, and which of the factors mentioned above is incorporated into the loan and might affect the loans you take. You can pay back the loans in fractions throughout the year.