Interest rates influence the liquidity and financial stability of banks and other lending institutions. Central banks monitor and adjust these rates to control inflation, regulate economic growth, and stabilise national currencies. By carefully balancing interest rates, policymakers can ensure that credit remains affordable without leading to excessive borrowing or an overheated economy.
Therefore, it is crucial for you to understand that when you apply for a loan, not all interest rates are equal. Lenders offer various types of interest rates, each with its characteristics, advantages, and drawbacks. In this blog, we highlight different types of interest rates you should know before applying for a loan.
An interest rate is the cost of borrowing money from a financial institution, usually shown as a percentage of the loan amount. When you take out a loan, the interest rate determines how much extra you will pay on top of repaying the principal loan amount.
For example, if you take out a personal loan of Rs.5,00,000 with an interest rate of 10%, you will pay Rs.50,000 as interest over the loan period. This interest compensates the lender for the risk of lending you money and the opportunity cost of not using their money elsewhere.
Lenders offer various types of interest rates. These include:
A fixed interest rate stays the same throughout the loan term, which means your monthly payments on the loan amount will not change. This stability makes it easier to plan your finances because you always know exactly how much you need to pay each month. It can be beneficial if you are working with a tight budget.
The predictability of such a type of interest rate shields you from potential increases in future interest rates. However, fixed rates can occasionally be higher than variable rates. In situations where the market interest rate decreases, you have to pay the initially agreed-upon higher fixed rate.
A simple or regular interest rate is calculated only on the principal amount of the loan. It does not consider any previously paid or accrued interest. This interest rate usually applies to short-term loans like personal and auto loans.
The beneficial part is it doesn’t change with the market conditions. Once you know the principal amount, the interest rate, and the period, you can calculate the total interest payable throughout the loan term. This upfront calculation provides clarity and better financial management.
A variable or floating interest rate fluctuates based on market conditions. Your monthly payments may change over the loan term, depending on the movements of the benchmark interest rate, such as the RBI’s repo rate. Thus, the percentage of borrowers that adopt this rate is lower because of uncertainties in the repayment amount.
However, it can save you money if the market rate decreases. Your monthly payments will be lower when interest rates are low, which can be beneficial in a falling-rate environment. But every coin has two sides. This uncertainty can make your payments higher once the interest rate increases.
The compound interest rate is ‘interest on interest’, calculated on the initial principal amount and the accrued interest from previous years. In simple language, it adds the interest amount to the principal, and the future interest calculations are based on this increased amount.
However, compound interest rates can also be more expensive for long-term loans, as the interest continues to accrue on the increasing principal amount. It can lead to higher overall interest payments compared to a simple interest loan.
Choosing the right type of interest rate for your loan depends on multiple factors, including your financial situation, loan term, and risk tolerance. Here are some considerations to help you make an informed decision:
A fixed interest rate is worth considering if you have a tight budget and want to avoid the uncertainty of rate hikes.
A variable interest rate might suit you if you're willing to accept some risk for the potential of lower payments.
A simple interest rate could work well if you take a short-term loan or prefer a linear interest calculation.
A compound interest rate is right if you can pay off your loan quickly or don't mind paying more interest overall.
By carefully considering the benefits and cons of fixed, variable, simple, and compound interest rates, you can pick the option that suits your preferences, budget, and long-term financial goals.
After comparing these interest rate options, signing up with platforms like Quid can help you select loans based on these types of interest rates, potentially saving you money throughout the loan term.
An interest rate is a percentage cost of borrowing money from financial institutions.
You can choose the most suitable personal loan options on platforms like Quid based on your financial goals and risk tolerance.
Multiple factors, like your income level, credit score, credit history, relationship with lenders, and more, decide the interest rates.
Yes, you can negotiate interest rates with lenders, especially if you have a good credit score or repayment history. Comparing offers from multiple lenders on Quid can also help secure a competitive rate.
Central banks raise the repo rate during high inflation, causing commercial banks to increase interest rates. In downturns, they lower the repo rate, leading to lower interest rates to boost borrowing and spending.
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