How Is The Interest Rate On Personal Loan Calculated?

When a personal loan is taken, the borrower and the lender agree on an interest rate that will be charged for the principal amount. Of course, the borrower would have bargained for a low interest rate on this loan, and the lender would have scrutinised the individual’s creditworthiness and prevailing repo rate before finalising the deal.

Factors Affecting The Interest Rate

Commercial banks and non-bank lenders determine the interest rate on loans keeping in mind the Reserve Bank of India’s monetary policy. But various other factors like age of the borrower, work experience, and whether the borrower is salaried or self-employed also influence the interest rate.
Apart from these, there are many other aspects that affect how a lender calculates the interest rate on a loan. For instance, the loan amount and the credit score—also known as the CIBIL score—play a part in the decision-making process and affect the rate of interest offered by the lender.

Calculating The EMI

Now that the deal has been locked, how does one calculate the installment that will be paid to service the personal loan?
The formula that is usually used by lenders to calculate the equated monthly installment (EMI) is:

          EMI= [P x R x (1+R)^N]/[(1+R)^N-1]
          EMI = Equated Monthly Installment
              P = Principal Amount
              R = Monthly Rate of Interest
              N = Loan Tenure in Months

If the equation appears complicated, let’s understand it with the help of an example. Suppose the principal amount of the loan is Rs 1 lakh, the interest rate is 10% per annum and the duration is five years. In this case, the EMI would be Rs 2,125.
This means the borrower would pay a total of Rs 1,27,480 over five years to the lender. Of this, Rs 27,480 will be the interest charged.

   Total Payment = Principal Amount + Total Rate of Interest
            Rs 1,27,480 = Rs 1,00,000 + Rs 27,480

The Two Components: Principal And Interest

The EMI of a personal loan, or any other loan for that matter, has two components—principal and interest. The interest component decreases over the years while the principal portion rises.

• On the personal loan mentioned above, in the first month’s instalment of Rs 2,125, the principal will be Rs 1,291 and interest Rs 833.
• However, in the last month’s instalment, the principal amount will be Rs 2,107 and interest just Rs 18.

So, the lower the tenure the less will the interest that will be paid to the lender.
Let’s say an amount of Rs 1 lakh personal loan has been borrowed at an interest rate of 10% per annum for three years instead of the five years mentioned in the first example.
Now, the EMI will rise to Rs 3,227, but the total pay-out over three years will be Rs 1,16,161. Hence, the borrower will pay a lower interest of only Rs 16,161.

                        Total Payment = Principal Amount + Total Rate of Interest
                                     Rs 1,16,161 = Rs 1,00,000 + Rs 16,161

This calculation is true for all fixed-rate loans, whether a personal loan or other products like vehicle financing. But the formula as well as the EMIs will change if the loan is borrowed on a floating rate of interest.

EMI On Floating Interest Rate

The EMIs on a floating rate of interest will change with any revision in interest rates charged by the lender, depending mostly on the repo rate of the Reserve Bank of India. In such a scenario, EMIs will rise when the lender revises the lending rate upwards and will fall in the case of a rate cut.
Personal loans are mostly at fixed rates, but in case there is an option to borrow at a floating rate of interest, one should look at the stance of the Reserve Bank of India.
If the central bank is likely to hike rates, then going for a fixed interest rate on a personal loan is sensible. Instead, if there are chances of the RBI cutting its repo rate, then it would be prudent to consider a floating rate.

Additional Costs

The final repayment to the lender for all personal loans includes application fees and the tax on them. So, it is a good idea to include such extra costs into the calculation.
For instance, lender A charges an application fee of Rs 5,000, plus taxes, and an interest of 10.0%, while lender B waives the application fee, but charges an interest rate of 10.2%. So, for a loan of Rs 1 lakh, which is the best deal?
Let’s calculate:
The total amount to be paid to Lender A and lender B are:

Lender A	Lender B
Rs 1,27,480 + Rs 5,000 + Rs 900 (GST) = Rs 1,33,380	Rs 1,28,072 + Rs 0= Rs 1,28,072

Hence, a low interest rate may not lead to a lower personal loan repayment amount if the application fees are high. Loan applicants must take that into account when negotiating for a personal loan at a low interest rate.

Prepayment

Most lenders will have a lock-in period before which a personal loan cannot be prepaid.
Another thing to keep in mind for prepayment is charges and when to prepay the loan. If the prepayment charges are high and most of the loan tenor has passed, it may not make much financial sense to go ahead with it. This is because as the loan tenor advances, the interest component falls.
Hence, when prepaying one should do a calculation of the principal and interest left on the loan.

Conclusion

The principal loan amount and the interest payable every month together is the total amount to be repaid to the lender during the entire tenure of the loan term. Initially, the interest amount constitutes a major portion. But after a considerable time of the loan period, the portion of interest repayment decreases.
Now that you know how the total interest amount is calculated for a personal loan, get your personal loan calculator and Excel sheet. Do the calculations and check what works best for a personal loan.
If you need personal loans, visit the nearest branch of IIFL Finance and secure the funds in just a few hours. If you are running short of time, apply online on IIFL Finance website and get your loan processed in less than five minutes.