Interest is a crucial aspect of the financial system since it encourages capital flow and enables credit and loan issuance.
When the extra payment is made to a lender on top of the principal amount, it is called as interest. The rate of interest is stated as an annual percentage rate (APR), and it could be fixed on a principal amount or can also change over time.
Understanding interest rates on a personal loan
The interest rate on personal loan is applied to the principal, which is the loan amount. The cost of debt is what the borrower pays in interest, while the lender receives the interest as a return. The amount to be repaid by borrower is frequently greater than the amount borrowed. The interest charged is the difference between the total repayment amount and the principal loan amount.
The lender will often impose a lower interest rate on the borrower if he/she finds him/her to be of low risk. If borrower is deemed to be of high risk, they will be charged a higher rate of interest, which increases the overall cost of the borrowing.
Types of interest rates
Here is a breakdown of the different types of interest rates offered and how each may affect the principal sum borrowed and the overall repayment.
- Fixed interest rate
A fixed interest rate is exactly what it sounds like: a specific, fixed rate tied to a loan that must be paid back along with the principal every month. Fixed rates are the most common type of interest rate for borrowers because they are easy to calculate and simple to understand. The benefit of fixed interest rate is that you know exactly how much you will be paying during the loan tenure. Thus, those who wish to plan their monthly expenses in advance can go for a fixed interest rate on personal loan.
- Floating interest rate
A floating interest rate is one that changes over time in reaction to economic variables including inflation, credit supply and demand, and central bank choices about monetary policy. The specific benchmarks for figuring out your variable interest will be set by the terms of your loan. With floating interest rate, your EMI payable will change during the repayment tenure. Floating interest rate is usually charged on products like a home loan.
- Simple Interest rate
Simple interest is also known as regular interest. Simple interest is the percentage charged on the principal amount for a specific tenure. It includes the simple calculation of how much you owe the lender without considering any other factors such as time, inflation, or payment schedule. Simple interest is easy to figure out because of its simple formula:
Simple interest = principal x interest rate x tenure
- Compound interest rate
Compound interest, also known as ‘interest on interest’, is calculated on the principal as well as the cumulative interest accrued over the time. Compound interest is based on two key elements: the interest of the loan and the principal loan amount. Here, lenders first apply the interest on the principal loan amount, and whatever balance is pending by the next year will be used to calculate the subsequent year’s interest payment.
Factors affecting interest rates
Many factors play a big part in influencing the prevailing interest rates:
- Government's instructions to the central banks for.
- Inflation rate
- The expected chance that the borrower will default.
- Market supply and demand.
- Fiscal deficits and government borrowings.
Personal loan interest rates
Personal loan interest rates are charged by lenders for borrowing money for personal expenses such as medical bills, home repairs, or higher education. These rates can change depending on a few factors, such as the borrower's income, credit score, and loan amount.
While people with a low credit score may be subjected to higher rates or may have difficulties in getting a loan. Borrowers with a good credit score and stable income may be eligible for lower interest rate. When applying for a personal loan, you should carefully read the personal loan interest rate and charges.
