Around 41% of personal loan applicants consider interest rate the primary factor when choosing a lender (1). Knowing the amount of interest payable and ways to minimize such costs helps streamline the repayment process. Moreover, borrowers must distinguish between the two types of interest, namely, simple and compound interest.
While most loan products in India follow the simple interest calculation method, other financial products rely on the compound interest rate formula.
Understanding the definition of compound interest
In a compound interest method, the interest amount is added to the principal sum. During subsequent interest calculations, this new figure is considered the principal. Consider the following example to acquire a better understanding of how compound interest works.
Suppose an individual avails a loan of Rs.1 lakh for 5 years at a compounding interest of 10% per annum. After the first year, it would incur interest of Rs.10,000. Therefore, his new loan principal would be Rs.1 lakh + Rs.10,000 or Rs.1.10 lakh in the second year. The borrower’s interest calculation for that particular year would be conducted on Rs.1.10 lakh and not Rs.1 lakh.
Under a simple interest calculation method, the principal amount would remain unchanged at Rs.1 lakh for the entire 5-year duration. Borrowers are liable to bear decreased interest costs on loans in this case. Thus, the type of interest is a major factor affecting the personal loan interest rate.
Formula for calculating compound interest
the compound interest rate formula remains unchanged, whether one is computing liabilities for a personal loan or returns from an investment product. It is as follows –
A = P (1 + r/n) ^ nt
- A = Total amount payable
- P = Principal sum
- r = Annual interest rate
- t = Tenor or number of years
- n = Compounding frequency (number of times in a year that interest is compounded)
Compound interest = A – P
The following example should clarify the process of calculation further –
An individual avails a personal loan of Rs.15 lakh for 3 years at 12% interest, compounded annually. In such a case, the various factors for calculation are as follows –
- P = Rs.15,00,000
- r = 12%
- t = 3 years
- n = 1
Placing each in the above formula, an individual gets –
A = 15,00,000 (1 + 12/1) ^ 1×3
A = Rs.21,46,153
Compound interest = Rs.21,46,153 – Rs.15,00,000 = Rs.6,46,153
Dividing the total amount by 36 months reveals that such a borrower would need to pay Rs.59,615 as EMI to repay his/her dues.
On the other hand, a similar loan on simple interest would cost significantly less to borrowers. In such a case, the interest burden would be limited to just Rs.2,93,573. Similarly, the EMI would be just Rs.49,821. Therefore, one of the ways to get the best personal loan rates is to apply for simple interest options only.
Individuals looking to secure the best rates on their loans can adopt other practices or methods as well.
Compound interest on loans can complicate repayment, forcing one to bear increased EMIs. However, a range of other factors also plays a role in determining interest charges. The borrower’s eligibility aside, even macroeconomic factors, such as repo rate, can determine how much one pays as interest on their personal loan.
Tips to minimize interest cost on loans
After acquiring a deep understanding of how simple and compound interest methods work, borrowers must utilize other ways to lower their interest burden.
- Build your credit score
While one can get a personal loan with a poor credit score, doing so can lead to increased interest payments. According to surveys, 90% of loans sanctioned presently are to individuals who enjoy a credit score of 750 or more (2). One can pay existing dues on time, maintain a favorable credit mix, and minimize FOIR to effectively build his/her creditworthiness.
- Fulfil all eligibility criteria
Besides building the perfect CIBIL score for a personal loan, borrowers must also meet additional eligibility parameters. Monthly income and age are common criteria for most lenders. Exceeding the minimum income requirement can entice lenders to offer personal loans to a borrower at favorable terms.
- Look for pre-approved offers
Financiers, such as Bajaj Finserv, provide pre-approved offers to accelerate and streamline one’s borrowing process. Such offers, available on personal loans and business loans, can lead to better terms apart from just increasing the convenience. Borrowers can check their pre-approved offers easily by providing name and contact information.