A breakdown of loan interest rates and what they mean

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When it comes to applying for a loan, there are many options available today. Banks and lending institutions offer a variety of flexible loans for different purposes. There is one parameter that is considered as a deciding factor while picking the most suitable lender, and that is the interest rate. This is of great importance because it can cause a considerable difference in the amount that would be repaid. Therefore the ease of repayment of a loan depends on the interest rate on loan.

What is an interest rate on loan?

The lender who lends the money adds an extra amount to the borrowed amount for offering the loan. In other words, the borrower pays an additional sum of money along with the borrowed amount on taking a loan, and this would be the fee paid for using the lender’s money. The concept is very much similar to the interest rate that banks offer on savings accounts and deposits. This being the case where the banks use the amount that the customer deposits in the bank. When you have money in your bank they hold the money for a particular period of time, the bank then pays the customer an interest rate. The liquidity of the account and other factors determine the offered interest rate. In the same way, banks and lenders impose an interest rate on the borrowed amount.

What are the types of interest rates?

Depending on the type of loan you take, there are different types of interest rates. The calculation of the amount paid as the interest on the principal depends on the kind of interest rate calculated. When comparing loans it’s useful to use a website that shows you the full breakdown for each company, Mammoth Investor compares the top providers with detailed information.

Simple interest

Here the amount paid equals the multiplication of loan term by interest rate and principal. There is an interest rate specified errand it is paid either as the whole at the end of the tenure or split up across the term along with the monthly loan installment.

Compound interest

This is the typical type of interest used in savings accounts as well as for credit card accounts. Here the interest amount is calculated by applying the rate after adding the previous interest to the principal after each year.

Fixed interest

As the name indicates the process where the loan’s interest rate is predefined. All along with the tenure of the loan, irrespective of the economic conditions and market changes, the interest rate remains the same.

Variable interest

Variable interest or floating interest is where the lender specifies a range within which the interest rate can fluctuate during the loan tenure. The conditions like the bank’s performance and market situations can all influence the interest rate.

Discount Rate

Discount rates are calculated for lending money to financial institutions, and this is influenced by the cash flow and performance of the organization.

Annual Percentage Rate

The yearly Percentage rate is a figure that many customers use when they have to decide on which credit card to apply for. Here the annualized interest rate is taken into consideration. The higher your outstanding balance in the credit card, the higher would be the interest that you pay.

Prime Rate

This is a special rate that is fixed for individual customers. Banks might have their choice of favored customers and offer them lower interest rates on loans. In the case of the business loan scenario, the banks and government lending agencies might fix lower rates for reputable businesses and those with an excellent financial track record.

The most common types of loans that banks and lending agencies offer are-

  • Business loans
  • Home loans
  • Auto loans
  • Personal loans
  • Education loan

Interest rate figures might vary from one borrower to another depending on the following factors-

Credit score – this would be the bank’s way to understand your capacity to repay debts. This is calculated based on your income, previous spending patterns, credit card bill payment patterns, and more. Even if you have a clean record where you had never borrowed money, the credit score would be low. Most banks are ready to negotiate and offer a reasonable interest rate for borrowers with good income slab and a good credit score. Therefore, work on improving your credit score to fetch lower rates. This can significantly bring down your monthly loan installment.

The down payment or the borrower’s contribution is another factor that influences the rate of interest offered. Most banks would be ready to lower the interest rate not by blindly looking at the borrowed money but by comparing it with the borrower’s contribution. For those loans where the down payment is very less or zero, the interest rates would be very high.

Tenure of the loan is another influential factor that can lower or increase interest rates. For those who are willing to repay the loan in a shorter period, the banks might offer lower rates of interests. This is because the bank would be getting back the offered money in a shorter period. 

Study these factors before you choose the bank where you apply for a loan. This will help you better negotiate for a lowered rate of interest and therefore bring down the total amount paid.