When taking a loan, understanding how interest works is crucial to managing repayments and avoiding financial strain. Interest is essentially the cost of borrowing money, and lenders calculate it in different ways.
At Today Finserv Consulting India, we simplify loan interest concepts to help you make informed borrowing decisions. Let’s break down how loan interest works, its types, and factors affecting it.
What is Loan Interest?
Loan interest is the fee charged by lenders for providing funds. It is calculated as a percentage of the principal (loan amount) and can be either fixed or floating, depending on the loan type.
Why Do Lenders Charge Interest?
• Compensates the lender for risk
• Covers administrative costs
• Accounts for inflation and opportunity cost
When taking a loan, understanding how interest works is crucial to managing repayments and avoiding financial strain. Interest is essentially the cost of borrowing money, and lenders calculate it in different ways.
At Today Finserv Consulting India, we simplify loan interest concepts to help you make informed borrowing decisions. Let’s break down how loan interest works, its types, and factors affecting it.
What is Loan Interest?
Loan interest is the fee charged by lenders for providing funds. It is calculated as a percentage of the principal (loan amount) and can be either fixed or floating, depending on the loan type.
Why Do Lenders Charge Interest?
• Compensates the lender for risk
• Covers administrative costs
• Accounts for inflation and opportunity cost
Types of Loan Interest
A. Simple Interest
Simple interest is calculated only on the principal amount. It’s common in short-term loans like personal loans or payday loans.
Formula:
Simple Interest=P×R×TSimple Interest=P×R×T
• P = Principal loan amount
• R = Annual interest rate
• T = Time (in years)
Example:
If you borrow ₹1,00,000 at 10% p.a. for 2 years,
Interest=1,00,000×0.10×2=₹20,000Interest=1,00,000×0.10×2=₹20,000
B. Compound Interest
Compound interest is calculated on the principal + accumulated interest, leading to higher costs over time. Common in savings accounts, credit cards, and some loans.
Formula:
A=P×(1+Rn)n×TA=P×(1+nR)n×T
• A = Total amount
• n = Compounding frequency (monthly, quarterly, etc.)
Example:
For ₹1,00,000 at 10% p.a. compounded annually for 2 years,
A=1,00,000×(1+0.10)2=₹1,21,000A=1,00,000×(1+0.10)2=₹1,21,000Interest=₹1,21,000−₹1,00,000=₹21,000Interest=₹1,21,000−₹1,00,000=₹21,000
C. Fixed vs. Floating Interest Rates
Fixed Interest Floating Interest
Remains constant throughout the loan tenure Changes with market rates (e.g., RBI repo rate)
Predictable EMIs EMIs may increase or decrease
Common in personal loans, car loans Common in home loans
How is Loan Interest Calculated on EMIs?
Most loans (home, car, personal) use Reducing Balance Method, where interest is charged on the outstanding principal (not the full loan amount).
EMI Calculation Formula:
EMI=P×R×(1+R)N(1+R)N−1EMI=(1+R)N−1P×R×(1+R)N
• P = Principal
• R = Monthly interest rate (Annual rate ÷ 12)
• N = Loan tenure in months
Example:
For ₹5,00,000 at 12% p.a. for 5 years (60 months):
• R = 12%/12 = 1% = 0.01
• EMI = ₹11,122
Factors Affecting Loan Interest Rates
1 Credit Score (Higher score = Lower interest)
2 Loan Type & Tenure (Longer tenure = More interest)
3 Income & Repayment Capacity
4 Market Conditions (RBI policies, inflation)
5 Collateral (Secured loans have lower rates)
FAQs
Why do different lenders offer different interest rates?
Lenders assess risk differently based on credit history, loan type, and competition.
Does prepaying a loan save interest?
Yes! Prepaying reduces the principal, lowering future interest. Some lenders charge prepayment fees.
How can I reduce my loan interest?
• Improve credit score
• Opt for shorter tenure
• Negotiate with lenders
• Compare loan offers
Is simple or compound interest better for borrowers?
Simple interest is cheaper for borrowers, but most loans use reducing balance (similar to compounding).
Why does my EMI remain the same if interest rates rise?
In floating-rate loans, tenure may extend (not EMI) if rates increase.
