Interest Rates – Know the Meaning, Types, and How to Calculate Interest Rate

An interest rate is a percentage charged on the loan amount that you have borrowed. It is imposed by the lender over and above the principal loan amount. Your Equated Monthly Instalment (EMI) is based on the borrowed amount, the interest rate, and the tenure of the loan.

For Bajaj Finserv Personal Loans, interest rates range from 10% to 31%. Check your offer to know the interest rate applicable to you.

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An interest rate is a percentage charged on the loan amount that you have borrowed. It is imposed by the lender over and above the principal loan amount. Your Equated Monthly Instalment (EMI) is based on the borrowed amount, the interest rate, and the tenure of the loan.

Interest is the percentage charged or earned on money over time. The interest rate meaning lies in its function as the cost of borrowing or the reward for saving. It applies to loans, deposits, and investments, typically calculated annually.

Loan rates vary depending on factors like credit score, tenure, and lender policies. The market interest rate, influenced by inflation and monetary policy, affects how affordable loans are and how profitable savings become.

Key takeaway: Understanding your interest rate is crucial because even a difference of 1% can save you thousands of rupees over your loan tenure.

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: Difference between flat and reducing interest rate

Interest rates are a cost to the borrower, but they are a source of income for the lender. Companies compare the cost of borrowing with the cost of equity, such as dividend payments, to determine which source of funding is the least expensive. Understanding this helps borrowers appreciate why lenders charge interest and make better borrowing decisions. For borrowers, the total cost of debt includes other fees and charges that lenders apply, including processing fees and more. Read about all the fees and charges to make an informed decision.

Consumer loan interest rates are usually given as the Annual Percentage Rate (APR). This is the rate of return that lenders want in exchange for lending their money. On the other hand, the interest rate on a savings account or cash deposit at a bank or NBFC is called the Annual Percentage Yield (APY). Compounding is taken into consideration in this interest rate.
 

• APR (Annual Percentage Rate): The annual cost of a loan, including interest and other charges. It's what you pay to borrow.
• APY (Annual Percentage Yield): The annual return on savings, accounting for compound interest. It's what you earn on savings.
   

Why it matters: APY is typically higher than APR because of compounding, making savings more attractive whilst loans more expensive due to compound interest effects.

1. Short-term political gain

Lowering interest rates can give a short-run boost to the economy and may influence voter sentiment. However, most economists believe this effect is temporary and will be cancelled out by inflation.
 

2. Expectations of inflation

Interest rates are heavily influenced by expectations about inflation. Higher inflation expectations cause rates to rise, whilst lower expectations cause rates to fall. Central banks regularly track and adjust rates based on inflation targets.
 

3. Taxation changes

Taxes affect interest rates by changing supply and demand for loans. When taxes increase, loan demand may decline, leading to lower rates. When taxes decrease, disposable income rises, increasing loan demand and potentially raising rates.
 

4. Economic conditions

Interest rates vary based on overall economic health. Rates tend to rise during strong economic periods and fall during weak economies as lenders and borrowers adjust behaviour accordingly.

The loan interest rate you are offered is influenced by multiple factors—both economic and institutional. Whilst broader economic conditions like inflation, fiscal deficits, and stock market trends play a central role, other elements such as global investment flows and monetary policies also affect how rates are set.
 

Reserve Bank of India (RBI) Policy Stance

One of the key drivers is the policy stance of the RBI. When the central bank increases the present interest rate, borrowing becomes more expensive for lenders. This leads to a rise in the loan interest rate offered to consumers. As the cost of borrowing goes up, both personal and business loans tend to decline.
 

Your Credit Score

A higher credit score signals better creditworthiness, often resulting in lower interest rates. Conversely, a lower score typically means higher rates.
 

Loan Tenure

Longer loan tenures typically attract higher interest rates due to increased risk exposure for the lender.
 

Employment Type

Salaried employees, especially those with government jobs or MNC employment, often qualify for lower rates due to stable income.
 

Existing Relationship with Lender

Existing customers with good repayment history may receive preferential rates compared to new applicants.
 

Economic Indicators

Inflation rates, GDP growth, market trends, and global economic conditions all influence how lenders set their interest rates.

How lenders use economic indicators

Every lender uses these economic indicators to define their annual percentage rate (APR) range. That's why it's essential to compare interest rates from different financial institutions before applying for a loan. By doing so, you can secure the most favourable terms and minimise your overall repayment burden.
 

Important: Even a 1% difference in interest rate can result in saving thousands of rupees over your loan tenure.
 

Making informed borrowing decisions

Understanding interest rates empowers you to:
 

• Compare loan offers more effectively
• Calculate your total repayment burden
• Plan your budget accurately
• Choose between fixed and variable rates strategically
• Recognise how economic changes might affect your loan costs
• Negotiate better terms with lenders