Personal loans have become easily accessible with the emergence of financial technology. Banks and fintech companies have been pushing customers to take personal loans and made the loan sanctioning process simple, seamless and convenient.
While the reason to seek a personal loan could vary, an individual will be looking at the interest rate as the basic criterion of comparison with another lender. Apart from retail banks, there are P2P lenders that also offer personal loans claiming to lend at "low" interest rates.
If you do not wish to be blinded by the attractive selling tactics, it is wise to understand how the aplication of these interest rates work and whether the rate that is being offered to you is economical.
When it comes to personal loans there are two types of rate structures that are associated with the calculation of interest rates on personal loans.
The two types of interest rate calculations
There are ideally two kinds of interest rate structures, namely flat rate structure and reducing balance rate structure. The choice of structure helps decide how the interest will be calculated but the decision on what kind of interest rate structure should be chosen lies in the hands of the lender.
While the borrower cannot change the way a lender makes the decision, they can definitely make a choice on which lender to choose.
Flat rate structure
Under the flat rate structure, the interest on the loan is calculated based on the entire principal and the annual rate of interest associated with it.
The calculation is very straightforward. The rate of interest is simply multiplied with the loan amount and tenure. For example, if you were to take a loan of Rs 50,000 at the rate of 10 percent (per annum) for a period of 2 years, your interest will be calculated as (Rs 50,000 x 10%) x 2 = Rs 10,000.
As you can see, the interest amount to be paid on the whole principal is predetermined.
Reducing balance method
Also known as the 'effective interest rate,' this interest rate structure takes into account not just the loan amount, tenure and annual interest rate, but the monthly repayments made.
Once your EMI is predetermined, the interest is calculate at a fixed rate but on the balance of the loan that is left to be repaid to the lender.
For example, if your monthly EMI is Rs 10,000, the interest on your loan for the coming month will be determined by reducing the first monthly installment paid from the total loan amount.
Most lenders opt for the reducing balance interest rate structure as it fetches them higher returns. This means that if you were to compare the actual interest amount you will be paying at the end of the tenure at the same rate per annum, you will end up paying a larger sum under the reducing balance method.
The decision to choose a lower interest rate may not be the only thing you look at when you wish to take a personal loan, the total interest amount you end up paying will differentiate your cost of borrowing.