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April 20, 2022

Types of Loan Interest Rates

First of all… what is interest? basically in layman language, it is the extra sum of money which a lender charges from a borrower along with the principle amount. It can be acknowledged as the benefit which a lender receives while lending money to a borrower.


In context of loans, we have 3 types of interests:

  1. Fixed rate of Interest
  2. Flat rate of Interest
  3. Reducing rate of Interest

Fixed rate of Interest

Fixed rate of interest is the rate that is levied on a liability, such as a loan or mortgage. It may apply for the full life of the loan or only for a portion of the term, but it remains constant for a specified amount of time.

  • A fixed interest rate is a rate that is charged on an obligation at a constant rate.
  • Borrowers that desire perfect certainty on their payments amounts prefer a fixed interest rate.
  • In an escalating overnight rate environment, individuals with mortgages prefer to lock in a fixed rate rather than a changeable rate.

Borrowers who don’t want their interest rates to be inconstant during the length of their loans, thereby raising their interest expenditures and, by consequence, their mortgage payments, choose a fixed interest rate. This rate eliminates the danger of a floating or variable interest rate, in which the rate payable on a debt obligation might fluctuate based on a benchmark interest rate or index, which can happen out of blue.

Advantages

  • Certainty in payback amounts: Because the needed payment amounts are fixed, the borrower enjoys complete transparency.
  • Protection from overnight rate hikes: The borrower does not have to be concerned about overnight rate increases and their influence on their fixed interest rate.

Disadvantages

  • In the event that the overnight rate is low, a variable interest rate is likely to be lower than a fixed interest rate. In addition, lenders frequently provide a low variable interest rate during the first few years of payback.
  • There is no benefit from a drop in the overnight rate: Although a fixed interest rate is immune to the negative effects of overnight rate rises on a variable interest rate, it is equally immune to the positive effects of overnight rate drops.

Flat rate of Interest

Throughout the loan’s term, a fixed interest rate is applied to the whole loan amount. It does not account for the fact that the principal is steadily lowered by the monthly EMIs.
The nominal flat rate stated at the outset is significantly lower than the Effective Interest Rate. The following formula is used to compute the fixed rate of interest –

Interest payable/instalment = (interest rate per annum * number of years * original loan amount) / number of instalments.

Loan Calculation

Pros and Cons

  • Uncomplicated to Calculate and Track: The flat rate technique makes it simple to compute. Loan obligations made with a flat interest rate are clear. Both parties, the borrower and the lender, can simply trace them.
  • Transactions with In-Kind Loans: The method of calculating a flat rate of interest has been around since before money was introduced. It is the most common method of repaying a debt in regular instalments.
  • The total amount paid would be greater than in the case of reducing interest rate.

Fixed rate of Interest vs Flat Rate of Interest

The phrases “fixed rate” and “flat rate” may appear to be identical, but they are not. These are phrases that indicate price and percentage consistency from the perspectives of customers and producers. The word “fixed rate” refers to the yield or accrual on interest-bearing securities like bonds and loans. “Flat rate,” on the other hand, refers to a volume-based pricing strategy utilized by producers.

Reducing rate of Interest

In reducing rate of interest If partial payments are made in the middle of the term, the interest rate is reduced even further. It is often referred to as a declining interest rate. Each month, the interest rate is determined on the outstanding loan amount. Yearly rest occurs when the main amount decreases on an annual basis.

The EMI in this case is made up of the principal payments plus the interest due on the outstanding loan amount. Every EMI payment reduces the outstanding loan balance. The following month’s interest is computed only on the outstanding loan balance.

The following formula is used to compute the diminishing balance rate-

Interest payable/installment = loan balance x interest rate per installment

Pros and Cons

  • The key advantage of a reducing interest rate is that the applicant would pay less interest over time than with a flat interest rate loan.
  • However, because a flat rate loan is returned over a shorter period of time, the interest for the months paid in advance does not need to be paid. However, lowering the interest rate will have an influence on the payback period and the interest component.

Flat Rate of Interest vs Reducing Interest Rate

 

Flat Interest rate

Reducing Interest Rate

Interest calculation

Calculated as a percentage of the entire principal amount

Calculated based on the total amount of principal still owed.

Liability for interest

In comparison to the interest charged under the diminishing balance interest rate method, this rate is higher.

Interest rates are lower than those levied under the flat rate system.

Intricacy level of estimation

Calculation is easier than the diminishing balance system.

When compared to the flat interest rate scheme, it is more difficult to compute.

Who likes them the best, and why?

Farmers appreciate the flat rate interest rate scheme because it is easy to compute and comprehend.

People who live in cities favor the falling balance interest rate system since the overall interest obligation is lower than the interest rate due under the flat rate system.

 

 

Loans
About Abhinav Jangid

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