Interest rates on personal loans are usually determined on the basis of an applicant’s credit history, age, principal, repayment tenure, and several other factors. Because of this, it is likely to vary from one lender to another. However, there are three different approaches in which personal loan interest rates are calculated. They are:
- Flat interest rate
- Reducing balance interest rate
- Floating interest rate
Choosing the ideal type of interest rate among these three options could be quite tricky, especially if a person is unaware of the calculation methods. Thus, the very first step to choose the better option between flat and reducing balance interest rate is to understand the ins and outs of these two approaches.
Understanding the flat interest rate and its function
Flat interest rates are calculated on the fixed principal amount and remain constant throughout the entire span till that loan is repaid. Even though the outstanding loan balance comes down with gradual repayment, the interest charges remain unaffected. This type of interest rates is also termed as a fixed interest rate.
You must understand what is a flat interest rate and how much of it is being charged by a particular personal loan lender so that you can compare it with other rates. The affordability of a personal loan also depends on your choice of the interest rate.
The calculation method of a flat interest rate is the simplest when compared to the other two systems. The formula to calculate flat or fixed interest rates is:
Flat/fixed interest rate = Principal x Number of years for repayment x interest rate per annum / Total number of instalments.
Know about Reducing balance interest rate
Reducing interest rate is one of the most important things you must understand before signing a personal loan agreement. This type of interest rate, unlike flat rates, does not remain the same throughout the repayment tenure. Instead of calculating the charges on the overall principal amount, this interest rate is calculated on the outstanding balance of a loan.
As you keep repaying a loan, the remaining amount keeps coming down, thus bringing down the interest charges as well. The formula to calculate this interest rate is:
Reducing balance interest rate = Interest rate per monthly instalment x Outstanding loan balance
You must also draw a comparison between fixed vs floating interest rates on a personal loan. While the former will require you to pay the same interest rates throughout the repayment period, a floating interest scheme would charge varied rates during that period. Floating interest rates change as per market conditions and other related factors in an economy.
To assist you in understanding the chargeable interest rate and related EMIs, lenders have introduced online tools like personal loan EMI calculator. By accessing this calculator, you can understand the levied charges accurately.
Among various facilities, borrowers now also get to enjoy unique pre-approved benefits on loans. These offers are provided by companies like Bajaj Finserv on both secured and unsecured loans. You could enjoy a much easier and simpler application process thanks to these offers. Check your pre-approved offers online by providing certain details (like your name and phone number).
Flat interest rates are usually set lower than reducing balance interest rates. However, the former could result in overall lesser interest outgo. During the course of your loan repayment period, you might choose to switch between these interest rates as per your convenience. You must discuss these terms with your lender beforehand so that you get the option to switch anytime.