How is the interest rate calculated for a bank loan?

Updated: Feb 14, 2022, 17:13 ISTShare:

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When you take a loan, you are expected to repay the principal amount along with a certain percentage, as per the interest levied by the loan provider. The payment of this amount is spread throughout the tenure of your loan.

The total interest payable throughout the tenure is an important factor to be taken into consideration because it can significantly increase the total sum payable to the lender.

What are the factors used to calculate the rate of interest?

While the Reserve Bank of India provides guidelines on the rate of interest that banks can charge, the rate of interest charged by different loan providers is calculated taking into account different factors like:

CIBIL Score:

This score is a reflection of your creditworthiness. You may get a lower interest rate if your CIBIL Score is high

Type of Loan:

The rate of Interest will vary depending upon the type of loan you are availing. There are different rates, based on whether the loan is secured or unsecured, along with the product type

Repayment tenure:

Although this may not be applicable for all lenders, some banks/financial institutions may charge higher rates, if you require a longer tenure

Relationship with the Bank:

Banks/Financial Institutions may have discounted rates for various categories of existing customers.

There are two types of interest rates being offered for loans – Fixed and Floating. A Fixed Rate Loan is where you pay a single rate throughout your loan tenure. Floating Rate Loans are generally linked to a benchmark followed by the bank/financial institution and may change as the benchmark shifts, during the loan tenure.

Fixed Interest Rate:

A Fixed Interest Rate means that the Rate of Interest on the loan is fixed throughout the loan tenure. The advantage of Fixed Interest Rate is it would not change even if there are fluctuations or changes in the financial market conditions or any benchmark or internal cost used by the bank.

A Fixed Interest Rate becomes the first preference when the financial market is down. Consumers take the opportunity, by blocking or fixing the interest rate as per their preference. In simple terms, if you think that the financial market will not drop down below a certain point or foresee a rise in the interest rates, then choosing a Fixed Interest Rate shall be the best option to avail.

Floating Interest Rate:

Interest rate, which keeps on changing as per the market scenario, is termed as Floating Interest Rate. This type of interest rate depends on the benchmark rate followed by several lenders, so whenever the benchmark rate changes, the interest rate gets automatically revised.

You would be offered a margin on the benchmark rate, which would normally be fixed and the final rate that you pay may be either Benchmark + Margin or Benchmark – Margin, depending on the institution.

Benchmark changes over the loan tenure and accordingly, your rate of interest would also change during your loan tenure.

Comparison between Fixed and Floating Interest Rate

As compared to a Fixed Interest Rate, Floating Interest Rates are comparatively cheaper. Fixed Interest Rates are 1% - 2.5% higher than Floating Interest Rates. The increase and decrease in the Floating Interest Rate is temporary, as it varies as per the market trends, movement of the benchmark rates and as determined by the bank.

Benchmark rates:

Home Loans and other loans are now linked to the benchmark Repo rate. The bank decides the margin, however the changes in your effective rate would depend on how the Repo rate changes.

Repo rate:

Repo rate is a powerful arm of the Indian monetary policy that can regulate the country’s money supply, inflation levels and liquidity.

Repo rate linked Home Loans?

Repo rate refers to the rate at which commercial banks borrow money by selling their securities to the Central Bank of our country i.e. Reserve Bank of India (RBI) to maintain liquidity, in case of shortage of funds or due to some statutory measures.

Repo Rate linked Home Loan is the new Home Loan scheme introduced by banks, as per the regulation by RBI. Under this scheme, a Home Loan Rate of Interest for Floating Loans are benchmarked to the Repo rate. Repo-linked Home Loan depends on the RBI's Repo rate. Home Loan rates that are linked to the Repo rates are currently composed of a Repo rate + margin.

How does a Repo rate impact the Home Loan rates?

Like any other Floating Rate Home Loans, this loan also has two parameters: the reset frequency of the interest rate on your loan and spread on the benchmark. These two parameters together determine the interest rate you pay on your Home Loan throughout the loan tenure:

Reset frequency: The maximum reset frequency set by RBI for a Repo rate linked Home Loan is 3 months. However, the interest rate of your loan will change as per the reset date decided at the time of availing the loan. On that date, the interest rate will be determined based on the latest updated Repo Linked Lending Rate of the bank from which you have availed the loan.

Margin: The next component is spread over the margin that you pay over RBI's Repo rate for a Home Loan. There are two spreads applied on a Repo linked Home Loan i.e. the base spread + additional spread. The spread on a Home Loan is decided as per the loan amount and the risk group of the borrower. The margin would be fixed at the time of sanction.

Impact of Repo rate change and margin on your interest rate:

When RBI changes its Repo rate, the interest rate on your Floating Rate Home Loan will also change by the same basis points. Your EMI will change, every time there is a change in the Repo rate

For instance, if you have taken a Home Loan at a floating rate of 9% and after 2 months, RBI decides to lower down the Repo rate by 50 bps, hence, your Home Loan Floating rate associated with the Repo rate will also come down by 50 bps at a rate of 8.50%. Your EMI will change between 1 - 3 months, as the reset period of your Repo Linked Loan Rate is 3 months.

In conclusion, a Fixed Interest Rate is preferred when the financial market is down. You can take the opportunity by blocking or fixing the interest rate, as per your preference. It has lesser risks and is suitable for short term loans with a fixed monthly outflow.

Repo rate linked Home Loans are a very transparent system of rates introduced by the RBI to benefit loan borrowers, these rates are linked to an external benchmark and banks have to pass on the benefit of reduction in the benchmark to its borrowers. This is suitable for long term loans and can generate savings in the long run.

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