What is the most common question we ask while applying for a loan? The question on their mind is about the Interest Rate the lender is going to charge. And often, the answer of this question decides whether we’ll proceed with the loan application or not. But do we really understand what ‘Interest Rate’ is and how is it charged? To help us take an informed decision, let us find the answer these questions today.
Here are a few important terms before we proceed:
Principal Amount – The amount of money a lender lends to the borrower. This is the amount used for all Interest calculations.
Interest Amount – It is the cost of borrowing money. The lenders charge Interest on the amount they lend as a fee for the loan. Simply put, it is the difference between the amount borrowed and the amount repaid.
Interest Rate – The percentage of the Principal charged by the lender. It is also known as the cost of borrowing money.
Now let us understand how Interest is charged on the loan amount. There are two ways to calculate Interest; Simple and Compound.
Simple interest is the easiest method to calculate the interest charged on a loan and is based on the Principal amount. For example, if you’ve borrowed Rs. 100,000 at a fixed Interest Rate of 5% for a period of 3 years, you will pay an interest of Rs. 15,000 by the end of the tenure. The formula to calculate Simple interest is:
Simple Interest = (Principal X Interest Rate X Tenure in Years)/100
Compound Interest is calculated based on both the initial Principal and the accumulated interest from the previous periods of a loan thus increasing the interest exponentially over time. To understand this, let us use the loan details in the example above. A loan amount of Rs 1,00,000 taken for a period of 3 years at an Interest Rate of 5% that is compounded yearly. The Interest payable at the end of the tenure will be Rs. 15,763. You can calculate Compounded Interest by using the following formula:
Compound Interest = Principal X (1 + Annual Interest rate) ^Number of Years – Principal
Interest Rates are important for making informed financial decisions. For a better understanding of the Interest Rate and how it is calculated, always read your loan documents or contact customer care for a detailed conversation.