Borrowing money from banks and NBFCs always comes with the price you pay for using the funds. This cost is known as an interest rate. It's typically expressed in a percentage of the borrowed amount charged on an annual basis. An interest rate directly affects how much you will overpay for your loan. Let's find out how it works and the average loan cost available now in India.
What Is an Interest Rate?
An interest rate is a price lenders charge for giving money to you. From the borrower's perspective, an interest rate is the cost of debt, while lenders consider it a rate of return or profit. It's usually expressed in a percentage of the loan principal charged annually or for the entire loan life.
Types of Interest Rate
There are two main types of interest rates that lenders apply:
- Simple interest rate. A simple rate is calculated as a percentage of the initial loan amount. If you borrow Rs. 20 lakhs for 1 year with a simple interest rate of 10%, you will repay the total of Rs. 20 lakhs + (20 lakhs x 10%) = Rs. 22,00,000.
- Compound interest rate. Also known as "interest on interest," this rate applies to your loan principal plus any unpaid interest that accrues over the billing cycle. This way, your loan cost increases due to interest accumulation. The same loan for Rs. 20 lakhs for 1 year with a compound rate of 10% will cost you ₹22,09,426.13 in total.
How Does an Interest Rate Work?
An interest rate is determined by the lender based on your creditworthiness and applied to the amount you borrow, taking into account the repayment period. When you make your EMI payments, a portion of what you pay covers your principal amount, while the rest (usually the majority of the payment) goes toward your loan interest.
Each monthly installment paid on time gradually decreases your loan balance. This happens throughout the entire loan life until your debt is repaid in full. If you pay more than the minimum, you typically reduce your debt, meaning that the amount to which your interest is applied decreases. Thus, you lower the loan cost and save money.
Interest Rate vs. APR
While an interest rate refers to the cost of borrowing you pay to a lender for using money, an APR is a measure people use to assess the real cost of borrowing. APR is an annual rate that includes your loan interest rate plus any extra fees associated with your borrowing. The fees may include processing and application charges, late payment fees, prepayment penalties, and more. By evaluating an APR, you can better understand the cost of borrowing and compare various loan products.
How Much Do Personal Loans Cost in India?
On average, a personal loan interest rate in India ranges from 9.99% to 24% p.a. However, some options may come with APRs of 44%, especially for borrowers with less-than-perfect credit scores. One of the primary factors based on which the personal loan interest rate is calculated is the benchmark rate, also called the repo rate. This rate is set by the central bank of the country, the Reserve Bank of India (RBI), based on the economic conditions. Banks take it as a basis and charge an additional rate on that to make a profit.
What Factors Affect My Loan Cost?
The exact APR you will be offered is determined based on various factors, including the lender's policy, your creditworthiness, and the loan duration. Let's take a closer look at each criterion:
Lender's Policy
Each bank and NBFC sets its own interest rate ranges based on the repo rate. Therefore, it's recommended to pre-qualify from multiple lenders and compare their offers before applying for a loan. You might be surprised at how interest rates differ by lender.
Your Creditworthiness
A borrower's credit score is another key factor and determines closer to what value of the interest interval you will be offered at a rate. People with good and excellent credit are most likely to get the lowest possible interest rates, while those with lower scores tend to pay more for a loan or even be rejected.
Repayment Period
The longer repayment period comes with lower monthly payments, making your loan easier to manage. At the same time, your interest rate tends to be higher when it comes to longer-term commitments. This happens due to more risk associated with such loans. Additionally, the total interest paid will also be significantly higher as an APR is charged annually.
Principal Amount
The amount you borrow directly affects how much you will pay for a loan. A higher loan amount often comes with a higher APR. Plus, your interest will be applied to a higher principal. By decreasing your loan balance, you can significantly save on interest.
Extra Fees
Two loans may have the same interest rate, but one of them will be more expensive due to extra fees applied. For example, lenders may charge an origination fee that will be deducted from your initial loan amount. This way, you will get less money on hand while being forced to pay interest on the full amount (the one before the fee was deducted).
The Economy
Market and economy conditions and the state of economy also determines the interest rate. Factors like rising inflation limits consumers' purchasing power, and that's a consideration lenders make when setting loan interest rates.
How to Decrease Your Loan Interest Rate
Depending on the loan type, there may be other parameters that can affect the loan cost. Knowing them will help you get a lower APR and potentially save money on interest. Here are several factors that may decrease your loan cost.
Security
Borrowers who provide collateral to back their loan can count on a lower interest rate due to less risk for a lender. This is also a good option for people with bad credit who can't qualify for traditional borrowing options.
Down Payment
Some loans that require down payments (home loans or auto loans) can offer lower interest rates to people who pay more upfront. This is also a good solution for people who seek cheaper financing.
Co-Signer
Adding a third party with good credit and stable income to your loan application can improve your approval chances and result in a lower interest rate. Just keep in mind that a co-signer will be responsible for repaying the loan if a primary borrower defaults on it.
Closing Cost
Some loans may come with a closing cost you pay when closing the deal. Its amount and the time when you pay it will also affect your interest rate. If a borrower decides not to pay this cost upfront and rolls it into the loan itself, the interest rate will most likely be higher.
Type of Interest Rate Applied
An interest rate can be either fixed or variable. A fixed rate is one that remains the same over the loan life, while a variable one can change under certain market and economic conditions. A variable-rate loan typically comes with a lower initial APR. At the same time, it can rise at any moment, making your loan more expensive.
Bottom Line
The average APR on a personal loan in India is between 9.99% and 24.99% p.a., with some options may cost you up to 44% p.a. The exact rate is determined by a lender based on multiple factors, including its policy, state of market and economy, and a borrower's creditworthiness and financial shape.
An APR is an annual cost of borrowing, including all the fees associated with your loan. You can use it to compare loan offers and get a better understanding of the real loan price. There are also ways to decrease your loan APR. Knowing them will help you make better financial choices and borrow money at more favorable terms.