When you take a loan the interest rate is not always easy to understand. This is because lenders show it in ways making it hard to compare. You might see two loans with rates but they could end up costing you the same amount. On the hand two loans with the same rate could cost you very different amounts depending on how the interest is calculated.
Before you decide to take a loan you need to understand how the interest rate works, not the rate itself. This will help you make a comparison. In India, banks and other financial companies have to follow rules set by the RBI to clearly show their rates and charges.
What Are the Two Methods of Interest Calculation?
There are two ways lenders calculate interest on loans.
Flat Rate
The way is called the flat rate method. Here the lender charges interest on the amount you borrowed for the entire time you are paying back the loan. This means you pay interest on the amount even when you have almost paid back the loan.
For example if you take a loan of ₹1,00,000 at a rate of 10% for 3 years you will pay a total of ₹30,000 in interest. Your monthly payment or EMI will be ₹3,611.
Reducing Balance
The way is called the reducing balance method. In this case the lender only charges interest on the amount you still owe which goes down each month as you pay back the loan.
For example if you take a loan of ₹1,00,000 at a reducing balance rate of 12% for 3 years you will pay around ₹19,480 in interest. Your EMI will be ₹3,321.
Here is a comparison of the two methods:
* Flat Rate at 10%: interest is charged on the amount so you pay ₹30,000 in interest.
* Reducing Balance at 12%: interest is charged on the amount you still owe so you pay around ₹19,480 in interest.
A 10% flat rate is actually like an 18% reducing balance rate. Most banks and financial companies in India use the reducing balance method for loans so make sure to check before you sign.
What Determines the Rate You Are Offered?
When you apply for a loan the lender looks at a few things to decide what rate to offer you.
* Your credit score: if you have a credit score like 750 or more you will get a lower rate. If your score is below 650 you might not get the loan. You will have to pay a much higher rate.
* Your income and job: people with jobs at good companies get lower rates than those who are self-employed.
Your existing debts play a significant role; a hefty debt load signals higher risk to lenders, often resulting in elevated interest rates.
Also, your established relationship with the lender can influence the offer you receive.
What’s the usual interest rate range in India?
Personal loan interest rate in India typically fall between approximately 10.49% and 24% annually, contingent on your financial profile and the lender’s assessment.
Here’s a general idea of the rates you might encounter, based on your credit score:
* A score of 750 or higher could secure a rate between 10.49% and 13% per annum.
* A score ranging from 700 to 749 might yield a rate between 13% and 16% annually.
* If your score falls between 650 and 699, you could expect a rate between 16% and 20% per year.
* If your score is below 650 you might not get the loan. You will have to pay a rate between 20% and 24% per year.
Keep in mind that these are just examples and the actual rate you get will depend on the lender and your individual situation.
When you are looking at a loan offer the interest rate is not the thing that matters. You need to know whether it is a rate or a reducing balance rate and what your total repayment will be. You can use a calculator to compare the total cost of different loans. Even a small difference in the rate can make a difference in how much you pay in the end. For example if you take a loan of ₹3 lakh for 3 years a difference of 1-2%, in the rate could mean you pay ₹10,000 to ₹20,000 more in interest. It is worth taking the time to compare and find the deal.
