A Beginner’s Guide To Understand The Different Types Of Interest Rates On Loans

A debt consists of two components – principal and interest. Principal is the actual amount borrowed while interest is additional charge paid to use the principal. It is an income for the lender to provide the debt.

What Is An Interest Rate?

Interest rate is the rate at which the interest will be charged on the principal amount by the lender. There are various types of interest and as a borrower you should be aware of them.

Why Is Interest Charged On Loans?

Borrowers pay the interest because of the availability of additional funds at his disposal. While the borrower has the money, its purchasing power or real value can decrease. To cover up for the decrease in the value, the lender charges an interest.

Types Of Interest Rates

Following are the various types of interest rates –

• Fixed or Flat Interest Rate –

The interest rate is fixed and constant throughout the tenure of the loan. This is the most common type of interest rate charged and the rate is decided mutually among the borrower and the lender. Its calculations are simple and easy. Since the EMI will be fixed, it gives a clear picture to the borrower about his monthly repayment schedule. There is a clear understanding between the lender and the borrower. It avoids any risk of loan getting costly. The disadvantage is that it may be higher than the variable rate of interest currently available in the market.

• Variable Interest Rate –

The rate of interest charged moves up and down with the market or the index called prime or base interest rate. The borrower will have to pay a higher interest if the prime interest rate increases. But there can be a scenario where the prime interest decreases after the loan approval. In such a case, his interest rate will become cheaper than what was initially assigned to him.

• Annual Percentage Rate –

It is the amount of the total interest expressed annually on the total cost of the loan. It is common in credit card companies and credit card mode of payment methodology. Credit card companies apply this method when the credit card users carry forward a sum of their balance instead of paying the full amount.

• Prime Interest Rate –

It is the rate of interest charged by the banks and other lenders from the borrowers who have a good credit history. The rate is generally lower than the usual borrowing rate. It is generally linked to the Federal Reserve interest rate, the rate at which the banks borrow and lend from the Federal Reserve. It is given only to some of the privileged customers.

• Simple Interest Rate –

It is charged on the principal loan amount by the banks and other financial institutions. Its calculation involves the multiplication of principal, rate of interest and the number of months.

• Compound Interest Rate –

It is the addition of the interest to the principal. In other words, it is the interest on interest. It has two key factors, the interest and the principal amount. The new interest will be charged after adding the previous interest to the principal amount.

• Discounted Interest Rate –

It is not generally applicable to the public. It is applicable to the Federal banks to lend money to other financial institutions on a short-term basis. Banks may opt for such loans to cover up their lending capacity, rectify liquidity problems or prevent itself from a crisis.

Conclusion

Interest is charged on a loan to cover up any decline in the value of the principal lent. The borrower pays the interest for the availability of instant funds. There are various interest rates. You should be aware of the types of interests charged so that you may take an informed decision regarding the loan availed.

Whether you need a personal loan, home loan, loan against property, or a business loan, IIFL Finance has you covered. With competitive interest rates, flexible repayment options, and a seamless online application process, IIFL Finance has made the process of availing a loan easier.