Understanding Loan Interest Rates

Two loans with the same advertised interest rate can cost very different amounts. The way interest is calculated, whether the rate can change, and the fees attached all affect what you actually pay. This guide explains the terms you will see in loan offers in India, and shows with simple numbers why they matter.

What an interest rate actually is

The interest rate is the price you pay to borrow money, expressed as a percentage of the amount borrowed per year. On most loans in India you repay through equated monthly instalments (EMIs): a fixed monthly payment that covers the interest due for that month plus some repayment of the principal.

In the early years of a loan, most of each EMI goes towards interest. As the outstanding balance falls, a larger share of each EMI goes towards principal.

Fixed vs floating rates

Fixed rates stay the same for an agreed period. Your EMI is predictable, but you do not benefit if market rates fall. Some "fixed" loans are fixed only for the first few years and then become floating, so read the terms.

Floating rates change over the life of the loan. They are linked to a benchmark plus a spread (a margin set by the lender).

• Since October 2019, RBI has required banks to link new floating-rate loans to individuals, such as home loans and personal loans, and loans to micro and small enterprises, to an external benchmark. Most banks use the RBI repo rate. The rate must be reset at least once every three months.
• Older loans may be linked to internal benchmarks such as the MCLR (marginal cost of funds based lending rate) or the even older base rate. These tend to respond to repo rate changes more slowly.

If you have an older loan on MCLR or base rate, it can be worth asking your lender about switching to the external benchmark. There may be a fee, and the spread offered may differ, so compare the full cost.

Flat rate vs reducing balance

This is one of the most important and least understood differences.

• A reducing balance rate charges interest only on the amount you still owe. As you repay, the interest falls. Home loans and most bank loans work this way.
• A flat rate charges interest on the original loan amount for the entire tenure, even though you are repaying it every month. Flat rates are sometimes quoted for consumer durable loans, vehicle loans and some personal loans.

If a lender quotes a flat rate, ask for the equivalent reducing balance rate or the annual percentage rate (APR) before you compare.

How EMIs are calculated

The standard EMI formula on a reducing balance is:

EMI = P × r × (1 + r)ⁿ ÷ ((1 + r)ⁿ − 1)

where P is the loan amount, r is the monthly interest rate (the annual rate divided by 12, as a decimal) and n is the number of monthly instalments. Most bank websites provide an EMI table or schedule on request, and your loan agreement should include a repayment schedule.

Tenure: lower EMI, higher total cost

A longer tenure can make sense if it keeps your EMI affordable, but it is worth knowing what it costs. Making part-prepayments when you can is one way to reduce the total interest on a long loan.

What happens when a floating rate changes

When the benchmark rises, the lender can either increase your EMI or keep the EMI the same and extend the tenure. Extending the tenure feels painless but can add substantially to total interest.

RBI rules require lenders to tell borrowers clearly how a rate reset affects their EMI or tenure. When rates are reset, lenders must give borrowers options, such as increasing the EMI, extending the tenure, a combination of both, or prepaying, and, where the lender's policy allows, the option to switch to a fixed rate. Check any letters or messages from your lender about rate changes, and ask which option is being applied.

Look beyond the interest rate

The interest rate is only part of the cost. Others include:

• Processing fees, often a percentage of the loan amount.
• Insurance bundled with the loan. You are generally not obliged to buy insurance from the lender; ask whether it is optional.
• Documentation, legal and valuation charges, especially on home loans.
• Late payment charges if you miss an EMI.
• Prepayment or foreclosure charges. RBI rules generally prohibit these on floating-rate term loans to individuals for non-business purposes. Fixed-rate loans may still carry them.

The Key Fact Statement and APR

RBI requires regulated lenders to give borrowers of retail and MSME term loans a Key Fact Statement (KFS) before the loan agreement is signed. The KFS sets out the key terms in a standard format, including the annual percentage rate (APR), which reflects the all-in annual cost of the loan including fees charged by the lender. Use the KFS to compare offers on a like-for-like basis, and do not sign until you have read it.

Credit card interest

Credit cards work differently from term loans. If you pay the full statement balance by the due date, you usually pay no interest on purchases. If you pay less than the full amount, interest is typically charged on the outstanding balance, often from the date of each transaction, and you may lose the interest-free period on new purchases until the balance is cleared. Credit card interest rates are usually quoted per month and are much higher than most loans when annualised. Check the card's Most Important Terms and Conditions (MITC) for your card's rates.

How lenders decide your rate

Two people applying for the same loan on the same day may be offered different rates. Lenders typically consider:

• your credit score and history (see how credit scores work);
• your income and its stability, and your employer;
• your existing EMIs compared with your income;
• for secured loans, the loan-to-value ratio, meaning how much you borrow compared with the value of the property or asset;
• your existing relationship with the lender.

A checklist before you borrow

1. Is the rate fixed or floating? If floating, what is the benchmark and the spread?
2. Is it a flat rate or a reducing balance rate?
3. What is the APR in the Key Fact Statement?
4. What are the processing fees, insurance and other charges?
5. Are there prepayment or foreclosure charges?
6. What happens to your EMI or tenure if the rate rises?
7. Can you afford the EMI if your income dips or another expense comes up?

If you have a complaint about a bank or NBFC, raise it with the lender first. If it is not resolved, you can escalate to the RBI Ombudsman through the RBI Complaint Management System (opens in a new tab).