## What is an Interest Rate?

The interest rate is a certain percentage of the principal loan amount a lender imposes on a borrower. If you have availed of a loan, you are expected to pay a certain percentage of the amount as interest along with the principal amount. This amount is charged throughout the loan tenure. It is usually calculated on an annual basis with respect to the money utilized by the borrower.

The interest can either be simple or compounded. Simple interest (SI) is mainly calculated on the principal amount, while compound interest (CI) is the interest on interest. It is calculated on the summation of the principal amount and the interest accumulated on it every time.

#### KEY TAKEAWAYS

• Personal Loans and credit cards are imposed with high-interest rates, but they do not require collateral. While Home-Equity Loans and small business loans come with low-interest rates, they require you to put some assets as collateral.
• The loan duration, especially the compounding periods, can play a major role to turn the tides in your favor.
• The net interest margin that a bank earns is actually the difference between what it earns on loans minus what it pays out as interest on the deposit. Moreover, that’s what decides the interest rate that will be levied on your loan amount.

## Simple Interest vs Compound Interest Rate

Simple Interest: It is the cost of borrowing imposed on the principal amount of the loan. It is easy to calculate as it is based on the original loan amount and not the accumulated amount. Therefore, it is beneficial for borrowers because there is no component of compounding, and it demands them to pay the interest only on the original loan amount taken. However, investors often have to bear losses if their investments are based solely on simple interest.

Simple interest is often used to estimate interest on consumer loans and Car Loans. Besides that, it is also used to determine the return on investment with regard to the certificate of deposit.

Now, let’s understand how to determine simple interest with an example.

The basic formula for simple interest is:

Simple Interest = P*I*n, where P = Principal amount; I = Interest rate; and n = loan tenure

Example: Let’s suppose, the principal loan amount is ₹50,000 for 60 days, and the interest levied is 5% p.a. Here, P = ₹50,000; I = 5% p.a. or 0.014% per day; and n = 60 days

Hence, Simple Interest = ₹410.95

So, the total payable interest is ₹410.95. Here, you can conclude that the higher the loan amount or duration is, the higher the interest will be.

Compound Interest: Compound interest is calculated on the accumulated earned interest amount. Unlike simple interest, it is not based only on the principal amount but generates high interest by compounding the interest earned on the principal amount. Therefore, the higher the rate of compounding is, the higher the interest accrual amount will be.

As it helps investments grow exponentially because of the principal power of compounding, it is commonly used by investors. Banks, financial institutions, and individual lenders also use it with a variation in its frequency. It can be used on loans taken on a monthly, quarterly, or yearly basis.

Now, let’s calculate compound interest with an example.

Compound Interest (A) = P {(1+r/n)^(n*t)-1}, where A = Compound Interest; P = Principal loan amount; r = rate of interest; n = number of compounding periods; and t = loan duration

Example: Suppose Mr X invests ₹10,000 at the rate of 10% for five years on a half-yearly basis. Here, P = ₹10,000; r = 10%; n = ½ year i.e. compounding periods are 2; and t = 5 years.

So, Compound Interest (A) = 10,000* {(1+10%/2)^(5*2)-1} = 10,000* {(1+5%)^((10)-1} = ₹6,289.

Therefore, in this case, the corpus at the end of the tenure will be ₹16,289.

Here, the conclusion is that the higher the compounding periods are, the higher the interest will be.

## Difference between Simple Interest and Compound Interest

Simple interest is comparatively easier to calculate. If you have taken a loan with interest that does not compound, then all you have to worry about is the interest amount that needs to be paid in addition to the principal balance loan amount. It is better used in the case of mortgages or Car Loans.

Compounding interest is desirable for investments because it allows money to increase more quickly than it would under a simple interest rate. Compound interest comes into the picture when you need to determine the annual percentage yield.

From the borrowers’ point of view, simple interest allows them to pay off their debt in a shorter period. However, if their loan amount has compound interest levied on it, they are supposed to pay high monthly payments that are not affordable. In such a case, a borrower might consider refinancing the loan at a lower interest rate from another lender.

## Floating vs Fixed Interest Rate

Floating Interest Rate: A floating interest rate changes periodically while reflecting financial or economic conditions during that period. It often moves in tandem with a certain index or general market conditions. It is also referred to as variable interest rate because it keeps varying over the debt duration. It is equal to the base interest rate plus a margin. For example, interest on a debt is priced at a six-month Mumbai Inter-Bank Overnight Rate (MIBOR) + 2%. Hence, post the duration of every six months, the interest rate for the following duration will be determined based on the MIBOR at that time, plus the 2% margin.

fixed Interest Rate: As the name suggests, a fixed interest rate is the interest rate that remains the same throughout the loan tenure, irrespective of any change in the repo rates or lending rates by the Reserve Bank of India (RBI). Hence, it does not affect your EMIs as well. However, bear in mind that some lenders choose to offer loans at a fixed rate for a few years and then switch to a floating rate to earn more interest. For example, your bank offers you interest on savings at a 5% fixed interest rate for a year and then changes it to MIBOR + 1% for further years.

## Difference between Floating and Fixed Interest Rate

• The fixed interest rate remains the same throughout the loan tenure. It is not affected by the market conditions, and hence your EMIs remain fixed as well, which makes it easier for you to plan your long-term savings or monthly budget accurately. However, floating rates attribute uneven monthly instalments, making it difficult to plan your budget.
• Floating interest rates are often lower than the fixed rates offered by banks or non-financial institutions. So, even if it increases later, the chances are it would still be less than the fixed rate offered earlier.
• Moreover, even if the floating rate exceeds the fixed rate, it will not be applicable for the entire loan tenure. The probabilities are it might come down later because of the market fluctuations.
• So, if you anticipate an increment in the interest rate in the future, try to go with the fixed interest rate offered by the lender. However, if you believe the interest rate has a higher chance of coming down, it’s better to opt for loans at a floating rate.

## How is Interest Rate on a Loan Determined?

Banks zero in on interest rates in correspondence to the rates issued by the Federal Reserve. Some banks also decide on interest charges considering the rates levied by their competitors. Besides that, other factors that banks take into consideration are future inflation levels, stock market conditions, the demand and velocity for money throughout the globe, and more.

Also, if you visit a bank to open a deposit account, you might find each type of account has a different interest rate that majorly varies based on the bank or account you have applied for. Often, the traditional savings accounts, money market accounts, and the certificate of deposits earn the highest interest rates.

## Factors Affecting Interest Rates

Further, if you visit a bank for a loan, it will consider the following factors before closing the application:

CIBIL Score: Your CIBIL score is a reflection of your creditworthiness. If your credit score is high, the chances are you can avail of a bank loan at a lower interest rate and close the application sooner.

Repayment Tenure: Albeit this factor is not applicable in every case, it has been observed that if you are seeking a loan with a longer repayment tenure, some banks or financial institutions might impose higher interest rates.

Type of Loan: The interest rate also depends on the type of loan you have applied for. The interest rate might vary with respect to the product type and whether the loan is secured or unsecured.

Relationship with the Bank: If you have good terms with the bank, you might avail of a loan at discounted rates.

## Interest Rate vs Annual Percentage Rate (APR)

If you take any form of credit, like a credit card or a loan amount, you will certainly come across the terms—interest rate and annual percentage rate. These two conflated terms, though, refer to similar concepts, but they have subtle differences when it comes to their calculation. Hence, it is crucial to comprehend the difference between the two before you start evaluating the loan cost.

Interest Rate: It is a certain percentage of the principal loan amount that the lender imposes with respect to the funds utilized by the borrower. The interest rate is usually fixed based on the amount borrowed, the loan tenure, the principal amount, and the frequency of its compounding periods.

Annual Percentage Rate (APR): It refers to the annual rate that a borrower has to pay with respect to the funds borrowed. It usually signifies the original cost of funds over the loan tenure. It is mainly a loan expense that you need to incur for a certain duration.

While the interest rate is a certain percentage that you pay on your entire loan amount, APR comprises the interest rate, as well as any additional fee or expense that you are expected to pay to your lender.

 Interest Rate APR It is determined based on the client’s individual data, like their credit score. It is decided by the lender based on broker fees and discount points. It does not comprise any additional fee concerning the loan amount. It might include broker fees, origination fees, and closing costs. It provides a narrower look at what you pay while borrowing the amount. It provides a broader look concerning the loan expenses. A lower interest rate means you have to pay lower monthly instalments However, the total loan cost may still be higher. A lower APR means your total loan cost has also decreased to some extent, although your monthly payments are still higher. It is more favorable for Home Loans if you are planning to stay in your home for a shorter duration. It is more favorable for Home Loans if you plan to stay in your home for a longer duration.

## Interest rates on different types of loans

A loan amount is taken for a variety of purposes, such as for marriage, funding a new business, purchasing a car or home, etc. However, every type of loan comes with a different interest rate levied on it. Let’s take a look at a few such loans and data concerning their interest rates.

Personal Loans: You can avail of Personal Loans from banks for virtually anything—from paying your regular bills to buying a smart TV. Since, in this case, you need not put up any collateral, the loan is quite expensive and it is termed an unsecured loan. However, you need to submit your income verification or proof of asset that is equal to the worth you applied for.

Credit Cards: Credit cards are, in some ways, equivalent to small personal loans. If you pay the balance amount in full sans any delay, there will be no interest charges. However, if your debts remain unpaid, you will have to pay monthly charges until the full amount is paid.

Credit cards are mainly imposed with APR.

Home-Equity Loans: You can borrow your home loan against the equity you have built up. That means you can borrow the exact amount that you actually own. So, if the value of your house increases in the future, your loan amount can go up to that value.

Small Business Loans: These loans can be availed through banks and NBFCs. The purpose behind these loans is usually to set up a new firm or expand an established organisation. To avail of these loans, you have to submit a business plan for review. Besides that, you need to put up some personal assets as collateral against default on loan repayment.

## Final words

Before you apply for a loan, it is highly recommended to comprehend the above-mentioned terms in advance. If you want to pay off your expensive debts as soon as possible, go for a loan with an interest rate that does not compound. However, if you are an investor, there is no better deal to avail of than one that comes with compound interest. Again, if you have an eye for market fluctuations, choose a loan with a fixed or floating interest rate that suits you best. The bottom line is you need to be financially aware of the current trends because they can affect your savings and loan costs.

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