A Guide On Interest Rate Structures For Personal Loans

The reducing balance interest rate structure reflects the real cost of borrowing a personal loan, and credible lenders employ this method to decide the interest rate of personal loans offered by them.

Personal loans are a convenient option that can help fulfil your short-term and immediate financial requirements. With the advent of technology into the space of financial services, applying for a personal loan is now an easy and efficient process through digital platforms offered by several lenders. However, the key aspect of consideration before applying for a personal loan would be the interest rate being offered by the lender. The rate of interest of a personal loan decides the real cost of your borrowing.

Quite often, you might have noticed a variation in the rate of interest of personal loans being offered by different lenders. While most lenders offer affordable interest rates on personal loans, few lenders in the market swear by lower interest rates- a considerable point to question their claims. In this context, it is important to understand the interest rate structure of personal loans and safeguard oneself from being deceived by the myth of lower interest rates.

Types of Interest Rate Structures of Personal Loans

The interest rate structure applicable to a personal loan is exclusively fixed by the lender and the borrower has no say in it. There are two types of personal loan interest rate structures – Flat Rate Structure and Reducing Balance Rate Structure. Each of these structures operates differently and is calculated in separate ways that could have a bearing on the cost of borrowing.

  1. Flat Rate Structure

According to this rate structure, the interest amount of a personal loan is computed by factoring in the entire principal and applying the annual rate of interest to it. Say, for instance, you borrowed a personal loan of Rs. 1 Lakh for a tenure of 1 year at an annual rate of interest of 10 percent. Under the flat rate structure, the total amount of interest payable towards the personal loan at the end of the tenure shall be Rs. 10,000.

  1. Reducing Balance Rate Structure

Also termed the Effective Interest Rate (EIR), the interest amount is calculated by applying the annual rate of interest on the principal amount remaining after each monthly EMI is deducted. In short, monthly interest is levied on the remaining personal loan amount after each EMI repayment.

In the above example, after your EMI is decided, and the first monthly repayment is done, the interest is computed on the leftover loan amount and levied. This process is repeated until the entire personal loan amount to be paid becomes NIL.

Which Interest Rate Structure for a Personal Loan is Better?

Most lenders use the reducing balance rate structure for the calculation of the rate of interest of a personal loan that a borrower would be required to pay. Lenders avoid using the flat rate structure to calculate the rate of interest of a personal loan as the interest payable is relatively lesser than the interest calculated through the EIR structure. Although the flat interest rate structure is better, the borrower does not have any choice when it comes to opting for an interest rate structure. It is totally the lender’s prerogative.

In a nutshell, it is important to note that when few lenders claim to offer unbelievably low-interest rates for personal loans, they are quoting the flat interest rate that does not reflect the real cost of borrowing as indicated by a reducing balance rate. Do remember that the interest rate per annum under a flat rate structure is nearly half of the real rate under EIR. So, beware of lenders who claim to offer the lowest interest rates for personal loans, and instead opt for reliable financial platforms like Finserv MARKETS to apply for a personal loan. On Finserv MARKETS, applying for a personal loan is totally worth the effort!