How the interest rates are calculated in banks? Broadly speaking there are two types of Interest rates available in the banking sector.

1. Flat Interest rate

2. Diminishing Interest rate

Flat Interest rate:

An interest charge on the full amount of a loan throughout its entire term is known as Flat Interest rate.

For Example:

Take the following case

Loan amount: Rs.100000

Flat Int Rate: 10%

EMI: Rs.2500

Interest monthly outgo: 833.33

Principal Monthly outgo: 1666.67

Interest yearly out go: 10000

Principal Yearly out go: 20000

Following table depicts the interest out go and the Rate of Interest actually they charge.

So the actual amount we end up paying would be Rs.150000. So the actual interest rate charged is 22.83% (114.17/5)

Diminishing Rate of Interest:

Under Diminishing rate of interest the repayment is deducted (say every month) from the loan and the interest is charged only on the balance principal.

For Example: if instead of 10% p.a. flat rate (in the above example), interest is charged at 10% p.a. Diminishing balance rate, EMI amount would be Rs 2,124.70. You would pay Rs 833.33 as interest in the first month and Rs 1,291.37 (2,124.70 – 833.33) would be Principal Repayment. For next month interest will be charged only on reduced principal, i.e. 100,000 less 1,291.37 = 98,708.63. Interest for second month would be Rs 822.57 (98,708.63 * 10% / 12) and principal repayment would be Rs 1,302.13 (2,124.70 – 822.57). Thus over the tenure of the loan, you would end up paying Rs 127,482 (2,124.70 * 12 * 5).

Above Interest rates are levied while calculating the interest. Again there are two types of interest rates while sanctioning the interest rate for a loan. They were discussed as follows,

Floating Vs Fixed Rate of Interest:

With a floating rate lenders lift or lower the interest rate as Interest rates in the market change. This means your repayments may fluctuate over time. It may increase as well as decrease as market fluctuates.

With a fixed rate of interest loan, the interest you pay for a period is fixed for a period – usually between six months to Five years. At the end of the period if the loan tenure is more than the period loan rate automatically changes to Floating rate of interest.

Both the methods have its own merits and Demerits hence it is not fair enough to judge which one is better. Most of the loan accounts are charged with floating rate. However the loan rates are mostly determined by the Prime lending rate of the concerned banks. In most cases it will not exceed the PLR of the concerned bank. Whenever there is a change in the PLR of the bank there would be a raise or drop in the interest rate for all the loan accounts.