Fixed Interest Rate:
The most common type of interest rate is a fixed rate, which is usually what the lender charges the borrower of a personal loan. As the name suggests, the interest rate stays the same throughout the loan's repayment period.
Advantage: Predictable EMIs—you know exactly how much to pay every month.
When used: Commonly used for personal loans and car finance.
Variable Interest Rate:
A variable interest rate is the opposite of a fixed interest rate. In this situation, the interest rate changes over time based on several factors like the repo rate. Variable interest rate is typically linked to changes in the base interest rate, also known as the prime rate of interest.
Advantage: Can be lower initially, potentially saving money if rates fall.
Risk: EMI can increase if market rates rise.
When used: Typically seen in home loans.
Compound Interest Rate:
The term "interest on interest" refers to the compound interest rate method. Here, banks will first apply the interest to the loan amount, and then interest is also charged on the interest accrued.
Key point: Most loan products use this method in conjunction with fixed or floating types of interest.
Cost: Usually more expensive compared to simple interest because interest is charged on accumulated interest.
Compound Interest Formula:
A = P × (1 + r/n)^(nt)
Where:
• A = Amount accumulated after n years (including interest)
• P = Principal amount (initial amount of money)
• r = Annual interest rate (in decimal)
• n = Number of times interest is compounded per unit t
• t = Time invested in years
You can easily calculate your interest using a compound interest calculator or the formula above.
Simple Interest Rate
As the name rightly suggests, a simple interest is simply calculated at a fixed rate on the borrowed amount. It can be easily calculated by multiplying the principal, the interest rate, and the tenure.
Note: This method of calculating interest is not often used by banks and financial institutions on personal loans.
Simple Interest Formula:
I = P × r × t
Where:
• I = Interest earned
• P = Principal amount (initial amount of money)
• r = Rate of interest per time period (usually as decimal)
• t = Time in years
You can easily calculate using a simple interest calculator or the formula above.
Also read: Flat vs reducing interest rate
