Interest rates play a significant role in finance, and even if you haven’t taken a loan yourself, you’ve likely come across the term. But have you ever wondered about the factors that determine these rates? For anyone considering a loan, understanding the elements that affect interest rates is essential. This blog will explore the concept of interest rates and the variables that influence the total interest amount, helping you make informed financial decisions.
What Is Interest Rate?
An interest rate is the fee you pay to borrow money, usually expressed as a percentage of the loan amount each year. When you take a loan—whether from a bank, a credit union, or another financial institution—the lender charges you interest as the cost for using their money.
For example, if you borrow money to buy a car or a house, the lender adds interest to the loan, which you pay back over time along with the original amount borrowed (the principal). Interest rates can vary depending on factors like the lender, the type of loan, and the length of time you’ll take to repay it. In simple terms, an interest rate is what you pay to borrow money, or what a lender earns for lending it.
Types of Interest Rates
Broadly, there are 4 types of interest rates, let us discuss and understand them one by one.
- Simple Interest: Simple interest is calculated as a percentage of the principal loan amount only, and it doesn’t change over time. It’s known as the “regular interest rate” because the interest does not compound. For example, if you take a loan of Rs. 1,00,000 at a 5% annual interest rate, the total interest after one year would be Rs. 5,000, making it straightforward and predictable.
- Compound Interest: Compound interest is calculated on both the initial principal and the accumulated interest from previous periods. This means you’re paying “interest on interest.” If you take a loan of Rs. 1,00,000 at a 5% interest rate, in the first month, your interest might be Rs. 5,000, and the next month, interest is calculated on Rs. 1,05,000 (principal + previous interest), resulting in a higher EMI.
- Fixed Interest: In this type, the interest rate remains constant for the entire loan period, unaffected by market conditions or economic factors. A fixed interest rate provides predictability in repayment since the EMI amount stays the same.
- Variable (Floating) Interest: With a variable interest rate, the rate can change over the loan term based on market conditions, economic factors, or specific terms in your loan agreement. For example, you may start with a 5% rate, but the lender can increase it by 1% each time an EMI is overdue, causing your interest payments to fluctuate.
Difference Between Simple and Compound Interest and How to Calculate It?
The key difference between simple interest and compound interest lies in how the interest is calculated and accumulated over time. Here’s a clear breakdown of each:
Simple Interest:
- Calculation: Simple interest is calculated only on the principal amount throughout the loan period. It does not take into account any previously earned interest.
- Formula: Simple Interest=Principal×Rate×Time100\text{Simple Interest} = \frac{\text{Principal} \times \text{Rate} \times \text{Time}}{100}Simple Interest=100Principal×Rate×Time
- Principal: The original amount borrowed.
- Rate: The interest rate (usually annual).
- Time: The time period for which the interest is calculated (usually in years).
- Returns: Simple interest provides lower returns or interest charges when compared to compound interest, especially over long periods, because the interest does not compound.
- Example:
- Loan Amount: Rs. 50,000
- Interest Rate: 5% per annum
- Time: 3 years
- Interest Calculation: Interest per year=50,000×5×1100=2,500\text{Interest per year} = \frac{50,000 \times 5 \times 1}{100} = 2,500Interest per year=10050,000×5×1=2,500
- After 1st year: Rs. 52,500
- After 2nd year: Rs. 52,500
- After 3rd year: Rs. 52,500
The borrower pays Rs. 2,500 interest annually, but the principal remains Rs. 50,000 each year.
Compound Interest:
- Calculation: Compound interest is calculated on both the principal and the interest accumulated in previous periods. Over time, this leads to interest being charged on “interest,” which is known as “interest on interest.”
- Formula: Compound Interest=Principal×(1+Rate100)Time−Principal\text{Compound Interest} = \text{Principal} \times \left(1 + \frac{\text{Rate}}{100}\right)^{\text{Time}} – \text{Principal}Compound Interest=Principal×(1+100Rate)Time−Principal
- Principal: The original amount borrowed.
- Rate: The interest rate (usually annual).
- Time: The time period for which the interest is calculated (usually in years).
- Returns: Compound interest offers higher returns or interest charges over time, especially for long-term loans, because of the compounding effect.
- Example:
- Loan Amount: Rs. 50,000
- Interest Rate: 5% per annum
- Time: 3 years
- Interest Calculation:
- After 1st year: Rs. 50,000 × (1 + 5/100) = Rs. 52,500
- After 2nd year: Rs. 52,500 × (1 + 5/100) = Rs. 55,125
- After 3rd year: Rs. 55,125 × (1 + 5/100) = Rs. 57,881
In this case, the borrower pays Rs. 2,500 in interest in the first year, but the interest on the Rs. 52,500 in the second year is Rs. 2,625, and the interest on the Rs. 55,125 in the third year is Rs. 2,756.
Comparison:
| Feature | Simple Interest | Compound Interest |
| Interest Calculation | Only on the principal amount | On principal + accumulated interest |
| Formula | P×R×T100\frac{P \times R \times T}{100}100P×R×T | P×(1+R100)T−PP \times \left( 1 + \frac{R}{100} \right)^T – PP×(1+100R)T−P |
| Returns/Interest | Lower over time, constant each year | Higher over time, interest is “compounded” |
| Example | Rs. 50,000 loan at 5% for 3 years: Rs. 2,500 annually | Rs. 50,000 loan at 5% for 3 years: Rs. 2,500, Rs. 2,625, Rs. 2,756 |
In summary:
- Simple Interest: Interest is constant and calculated on the principal.
- Compound Interest: Interest increases over time as it’s calculated on the total amount (principal + interest from previous periods).
Factors Affecting Interest Amount
Below are the factors that affect the interest amount on the loan you take.
- Loan amount: Principal amount is the key factor responsible for the amount of interest rate. The higher your principal amount is, the higher will be the interest you’ll have to pay.
- Interest rate: Another factor that determines the interest amount is interest rate. Depending on the borrower and the terms of loan, the interest rate differs from one organization to another. A higher interest rate will result in a higher interest amount, while a lower interest rate will lead to a lower interest amount.
- Loan term: The time period of loan also affects the interest amount. However, the interest rate also depends on the policies of the financial institution.
- Repayment: The repayment schedule, such as equal monthly installments (EMIs) vs. interest-only payments, can affect the total interest paid. EMI schedules that pay down the principal faster will have lower total interest costs.
- Credit score: If you have a good credit score, you will be able to achieve low interest rates. A good credit score demonstrates your ability to pay back in time.
Before directly applying for any loan due to financial emergency, stop and understand all the related terms to prevent yourself from being exploited. First research and then take a step forward to make rational decisions and plan the future.
Disclaimer: Nothing on this blog constitutes investment advice, performance data or any recommendation that any security, portfolio of securities, investment product, transaction or investment strategy is suitable for any specific person. You should not use this blog to make financial decisions. We highly recommend you seek professional advice from someone who is authorised to provide investment advice.
