Things you need to know about loan rates

Banks and financial institutions provide various types of loans on different terms and conditions, the most important being the rate of interest. The higher the rate of interest on a given amount and specified period of loan, the higher the interest outgo as compared to a loan with lower rate of interest. This is quite simple and any literate person with basic arithmetical knowledge can understand this easily. But apart from the rate of interest, there are other factors that impact the amount of interest paid by a borrower. Let us take a look at these factors and how they impact the cost of borrowing.

Fixed rate vs floating rate: Bank and financial institutions usually offer to the borrower the option to choose between a fixed or floating rate of interest on long term loanssuch as home loans. A fixed rate loan assures the borrower that the rate of interest on the loan will remain fixed during the tenure of the loan, provided the differential between the original rate and market rate remains within the limit specified in the loan document. If the differential crosses the specified limit, the bank/financial institution reserves the right to revise the rate in line with the market rate. On the other hand, a floating rate loan is one where the rate of interest is revised as and when the RBI revises the interest rates. It is evident that a fixed rate loan would be beneficial for the borrower when the interest rates are expected to go up, while a floating rate would be beneficial when the interest rates are expected to go down. In the first case, the interest rate will remain pegged at a fixed level even as interest rates are rising, whereas in the second case, the borrower can avail the benefit of lower interest rates when interest rates are declining.

Flat vs reducing balance method: A flat rate loan is where the bank or financial institution charges interest on the initial principal amount of loan, irrespective of the amount repaid by the borrower. The flat rate method is not popular and banks nowadays usually do not offer loans on the flat rate method, but it may be adopted for very short duration loans. For long term loans, the reducing balance method is adopted to calculate the amount of interest that a borrower is liable to pay. In this method, the principal amount repaid by the borrower is deducted at specified intervals and, thereby, interest is levied on the reduced loan amount. The specified interval is called as the ‘rest’ and the ‘rest’ could be annual, quarterly, monthly, weekly or even daily. So, for example, if a borrower takes a loan on a monthly rest basis, the amount of loan repaid by the borrower during the month is deducted from the outstanding loan amount at the beginning of the month and the loan outstanding would be reduced to the extent of repayment and, accordingly, the interest payable on the remaining loan amount would also get reduced. Hence, the shorter the duration of the ‘rest’, the higher will be the benefit in terms of savings in interest outgo.