Different Types Of Interest Rates In India And How They Impact You
Gaurav is a young IT professional based in Hyderabad. A couple of days ago, he received a call from his bank, which offered him a personal loan of INR 10 lakhs at a 15% interest rate, payable in 24 monthly instalments. He immediately was interested as he had various plans, from a foreign holiday to buying a second-hand Harley Davidson motorcycle. He knew the interest rate was manageable, and the monthly instalments were within his salary range.
With no detailed knowledge of financial products, he thought of taking advice from his brother, who was a financial analyst. His brother asked him about the type of interest offered by the bank. Gaurav did not understand the question, as interest meant nothing more than paying a premium on borrowings.
His brother explained: “Interest rates vary depending on the type—fixed, floating, simple, compound, and even the central bank’s influence on market rates. The difference could mean paying thousands more over the years or saving big.”
This explanation made Gaurav realize that understanding different types of interest rates was crucial before making any financial decision. This awareness is not just important for him but for anyone dealing with loans or investments.
Suppose you have already taken a loan, are planning to take one, or are looking to invest in a fixed-income, interest-yielding investment. In that case, you must know the categories of interest and how they impact your financial journey. When you take a loan, you pay interest to the lender for using their money. Conversely, when you invest in a fixed deposit or savings scheme, you earn interest on your money.
Why Knowing Interest Types Matters
Interest rates are critical in determining the cost of debt and affect your dues and interest receivables. A higher interest rate increases loan repayment costs, while a lower rate makes borrowing more affordable. When you clearly understand different interest categories, it is easier to make an informed decision related to borrowing or putting money in interest-yielding investments.
Different Types Of Interest Rates
Depending on the loan, investments and regulatory guidelines, here are some of the common types of interest rate terms used in India:
Category Of Interest Rate | Explanation |
Fixed Interest Rate | The interest rate remains constant throughout the loan tenure. It offers predictability and stability, making it ideal for long-term loans like home loans. However, you might have to pay a higher interest if the real market interest rates fall. |
Floating Interest Rate | The rate fluctuates based on market conditions and central bank policies. It may lead to lower payments when rates drop but can increase borrowing costs when rates rise. Common in home loans and business loans and is controlled by RBI directives. |
Simple Interest Rate | Interest is calculated only on the principal amount. It follows the formula SI = (P × R × T) / 100 (where SI stands for Simple Interest, P stands for Principal, R stands for Rate of Interest, and T stands for Time Period), making it straightforward to compute. |
Compound Interest Rate | Interest is calculated on both the principal and the accumulated interest over time, following CI = P(1 + R/100)^T. (Where CI refers to Compound Interest, P refers to Principal, R refers to Rate of Interest, and T refers to the number of time period compounding is done) This leads to higher returns on investments but can also increase the cost of long-term loans. |
Prime Lending Rate (PLR) | The interest rate banks charge their most creditworthy customers. Other borrowers receive loans at rates above the PLR. |
Repo Rate and Reverse Repo Rate | The Repo Rate is the rate at which RBI lends money to banks, influencing overall interest rates. Reverse Repo Rate is the rate at which banks deposit excess funds with the RBI, affecting liquidity in the economy. |
Base Rate | The minimum interest rate banks can charge for lending. It replaced the BPLR system and ensured greater transparency in loan pricing. |
Marginal Cost of Funds based Lending Rate (MCLR) | Introduced in 2016, MCLR is the benchmark lending rate set by banks based on their funding costs, ensuring fair interest rates for borrowers. |
How Interest Rate Differs From Interest Type
Interest rate is the percentage charged on a loan or investment, while interest type is the application of such interest over a period.
1. Key Factors Influencing Interest Rate Variations
Different market forces and external factors affect interest rate variations, such as:
I. Inflation: A higher inflation results in curbing excessive money supply, making borrowing costlier.
II. Monetary Policy: A cut in the repo rate can make borrowing cheaper.
III. Credit Demand and Supply: High demand for loans may push interest rates up, while excess liquidity lowers rates.
IV. Global Factors: International interest rate trends (like U.S. Fed rate hikes) influence Indian lending rates.
2. Impact Of Interest Type On Loan Payment And Investment
Let us understand this with an example: If a bank offers a home loan at a 10% fixed interest rate, the borrower will pay the same EMI throughout the tenure. However, if the loan has a floating rate of 10% (subject to RBI repo rate changes), it could rise to 11% or drop to 9%, impacting the EMI amount.
Similarly, an INR 1 lakh loan at a 10% simple interest for 3 years will accrue INR 30,000 interest (SI = P × R × T = 1,00,000 × 10 × 3 / 100). In contrast, if the same amount is borrowed at 10% compound interest annually, the total interest will be INR 33,100 (CI = 1,00,000 × (1 + 10/100)³ - 1,00,000).
How Are Interest Rates Determined?
Interest rates depend on a wide range of factors, which have been described in brief as follows:
1. Role Of Central Bank (RBI)
The Reserve Bank of India (RBI) plays a crucial role in setting interest rates through monetary policy tools like the repo rate (the rate at which RBI lends to banks). A rise in the repo rate makes borrowing costlier, but it helps control inflation. A reduction in the repo rate makes loans cheaper and increases economic activity.
2. Market Forces And Economic Conditions Affecting Interest Rates
Market forces and economic conditions directly impact interest rates, including inflation, GDP growth, liquidity levels, and global trends. For example, a slowdown in economic growth (GDP) can lead to lower interest rates to stimulate activities.
3. Impact Of Credit Scores On Interest Rates
Individual credit scores (such as CIBIL ratings) affect the offered rate of interest. For example, a high score (750+) qualifies for lower interest rates, e.g., a home loan at 8.5% instead of 10%.
4. How Banks And Lenders Determine Interest Rates
Banks set rates based on risk-based pricing, loan type, and borrower profile. For example, secured loans like home loans (8-9%) have lower rates than unsecured loans like personal loans (11-16%).
Banks and lenders determine interest rates based on factors like loan supply and demand, central bank policies, and market conditions. Central banks influence short-term rates to maintain economic stability, while long-term rates depend on Treasury note demand (10 and 30-year notes). Retail banks adjust rates based on their business needs, while the Federal Reserve’s fed funds rate impacts overall borrowing costs.
Conclusion
Understanding different types of interest is crucial for making informed financial decisions. When choosing between fixed and floating interest rates on loans, it's essential to assess your risk appetite carefully. For investments, opt for higher-yielding compound interest instruments for better long-term returns. If you are unsure about how different interest types operate, it is always advisable to contact an expert. Log in to Grip Invest to explore a range of fixed-income investment options and make informed financial decisions with expert insights.
Frequently Asked Questions On Types Of Interest Rates
1. What is the most common type of interest?
Compound interest is the most common type used in savings accounts, fixed deposits, and loans, as it helps money grow over time.
2. Which type of interest is used in banks?
Banks primarily use compound interest for deposits and fixed and floating interest rates for loans, depending on the product and borrower profile.
3. Who determines the FD rates?
Banks determine FD interest rates based on the RBI’s repo rate, market conditions, and internal cost of funds.
4. What are the three types of interest on a loan?
The three main types of interest on loans are fixed interest, floating interest, and reducing balance interest (where interest is calculated on the outstanding loan amount).
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