What are Interest Rates and their Different Types

What is the Interest Rate that Banks Charge in Loans?

In lending, the interest rate is often calculated as the percentage of excess amount that burrowers pay back to the bank or money lender in addition to the original loan amount. Calling interest rate mere percentage is also an oversimplification as it includes various variables such as the loan duration, principal amount, and compounding frequency and other parameters.

Banks and money lenders are also allowed to charge their own interest rates on different types of loans, and in certain loans, the interest rate might be regulated by a statutory body.

Let's take a closer look at what is the interest rate involved in loans, including its different types.

Fixed vs Variable Interest Rates

Interest rates can be classified based on various types. This makes it even difficult to understand what is the interest rate that borrowers pay on certain types of loans, why do they vary, and what borrowers can do about them. One such important classification that you should understand is fixed interest rates and variable interest rates.

What are Fixed Interest Rates?

Borrowers may prefer fixed annual interest rates because they remain constant throughout the duration of the loan. This means borrowers only have to pay predictable and stable monthly payments [EMIs] that aren't affected by market fluctuations.

Fixed payment throughout the entire loan duration also makes more sense whether you are a business owner or a salaried employee, as it gives you space for managing other finances as well.

What are Variable Interest Rates?

Variable interest rates aren't permanently locked. Meaning, the rate of return fluctuates with market variations. Each month, the payment that borrowers need to make towards their loan can vary.

This unpredictive nature of payments can be harmful for certain borrowers, but when managed smartly, you can benefit from lower interest rates as well. However, loans with variable interest rates are only recommended to financial experts who can predict market volatility.

Key Differences Between Fixed and Variable Interest Rates

1. Fixed interest rates have stable monthly payments, whereas variable interest rates changes.

2. Fixed interest rates remain protected from market uncertainty. Variable interest rates fluctuate.

3. In variable interest rates, borrowers may save or lose some amount in repayments. In fixed interest rates, there's no such flexibility.

Annual Percentage Rate (APR) vs Annual Percentage Yield (APY)

When thinking about what is the interest rate, lenders think of the annual percentage rate (APR) and annual percentage yield (APY). Here's the different between the two:

1. Annual Percentage Rate (APR)

Annual Percentage Rate can be simply defined as the cost of borrowing amount for a year. These are the returns that lenders make on their investments in your loans along with additional costs, such as loan origination. APRs can be a little higher than simple interest and are inclusive of everything.

2. Annual Percentage Yield (APY)

APY is the total interest rate that banks earn. It is inclusive of any amount that is compounded in the interest rate calculation.

Understanding Loan Amortization

Understanding loan amortization is important when understanding what is the interest rate that banks charge on various types of financial products. Loan amortization refers to repayment process for any loan. Basically, it defines how much the monthly EMIs will be, what percentage will go towards interest payments, and what percentage will be adjusted against the loan amount.

With the interest amount reducing gradually with each repayment, the contribution towards the principal sum keeps increasing. These adjustments are also covered in loan amortization.

Amortization vs Non-Amortization

Again, both types of amortized and non-amortized loans exist, and both have their own set of benefits. In a non-amortization loan, the principal amount is not paid through monthly EMIs, instead it is paid at the very end in the closing costs. The interest is paid as defined in the loan agreements, which either as part lump-sum amounts or towards the very end along with the principal.

Key Factors that Affect your Interest Rate

What is the interest rate on specific loan applications depends on various factors. Banks and money lenders use various parameters to figure out and based on how well borrowers perform on those parameters, their interest rate changes.

1. Credit Score: The first and foremost is the credit score. Money lenders and banks rely heavily on an individual's credit score when offering them loans. Higher the score means lower the interest rate.

2. Loan Type: Certain types of loans, such as credit card loans, pay day loans, personal loans, etc., have higher interest rates as these are unsecured loans without any collateral. On the other hand, home mortgage loans, car loans, and certain types of business loans and financial products may have lower interest rates.

3. Debt to Income Ratio: Money lenders see high debt-to-income ratio as very risky. To cover this risk, the interest rate on such loans is generally high. Through the amortization process, the interest amount can be recovered fast.

4. Down payment or collateral such as real estate or home loan mortgage, decrease the risk for banks and money lenders. So, if you ask what is the interest rate in loans with collaterals, the interest rate is comparatively low.

5. Fixed or Variable Interest Rate: Loans with fixed interest rates often have higher rates in the beginning. On the other hand, the variable interest rates mean that the amount can increase or decrease depending on market performance.

Final Thought

“What is the interest rate?” is an important question that borrowers ask money lenders. It helps them analyze their repayment capabilities, measure risks, and make informed financial decisions. With complete knowledge on simple or compound interest rates, fixed and variable interest rates, and even about the loan amortization process, borrowers can compare multiple lenders and select the one that best matches their loan requirements.

Lastly, about the factors that decide the amount of interest, borrowers will need to actively maintain them. For example, they should pay attention to their credit score, keep constant checks on it, and timely report any errors to the governing body. Likewise, they can factor in the debt-to-income ratio to get favorable interest rates.