Types of Interest Rates Explained

Interest rates play the most important role in the world of money. They are not just a percentage, but the real cost of borrowing and investing. It is important to understand the different types of interest and types of interest rates, because some of them are such which type of interest can change over the life of a loan? That is, such interest rates which can change over time. In this article, we will understand 10 types of interest rates in simple language and know how they affect our financial decisions.

What is Interest Rate?

Interest rate is the price that is paid on any borrowed money. In simple words, if a loan is taken from a bank or NBFC, the additional amount that has to be paid on it is the interest. It is measured in percentage (%) and this rate decides how much your EMI will be or how much return you will get from the investment.

Why is it important to understand interest rates?

Interest rates are not just a number or percentage, but they affect your entire financial journey. Many people take a loan just by looking at the “low interest”, but do not understand whether the rate is fixed or variable.

Example : Suppose someone took a home loan and thought that the interest will always be 8%. But after a few years he came to know that he had chosen a floating interest rate, and after the change in RBI policies, the EMI increased to 10%. Result—he had to pay thousands of rupees more every month.

Interest rate game in banks and credit cards

Banks, NBFCs and credit card companies apply different types of interest rates. For example, personal loans and credit cards have higher interest rates because they are unsecured loans. On the other hand, home loans or car loans may have lower rates because they have collateral.

Why is it dangerous to look at only the percentage?

Most people look at the interest rate only as a percentage (%). But due to not understanding the “type” of the rate, the actual cost can increase manifold. That is, despite the low percentage, if the rate is compound or floating, then the payment in the end can be very high.

Read Also: A Guide To Fixed Deposits: Exploring Types And Interest Rates

The 10 Types of Interest Rates Explained

1. Fixed Interest Rate

What is it?

Fixed interest rate is a type of interest rate in which the interest rate remains fixed during the entire loan tenure and there is no change in it. Whether interest rates rise or fall in the economy, the EMI on your loan will remain the same as it was decided in the beginning.

How does it work?

When you take a loan from a bank, the bank offers a fixed rate. If you choose it, your EMI will be calculated at the same interest rate for the entire loan tenure. The bank locks this rate so that you have to pay the same installment (EMI) every month.

Advantages:

• EMI remains stable, which makes budget planning easier.
• Your loan will not become expensive even if the interest rate increases.
• You get peace of mind for a long time as there is no uncertainty in payment.

Disadvantages :

• Even if interest rates go down in the future, you will still have to pay the same high rate.
• Initially, the fixed rate can be a little more expensive than the floating rate.
• Some banks have a reset clause, which means the rate can be reset after 5–10 years.

Example : Many banks in India offer fixed rate home loans for 10–15 years. Suppose, someone has taken a loan of Rs 20 lakh at a fixed rate of 8.5%. For the next 15 years, even if RBI reduces the repo rate to 6%, the EMI of that person will remain the same.

This interest rate is best suited for people whose income is stable, like government employees or people with fixed salaries. Such people do not want to take risks and they want stability in EMI.

2. Floating Interest Rate

What is it?

Floating interest rate is a type in which the interest rate of the loan keeps changing from time to time. This rate depends on RBI policies, repo rate, and market conditions. That is, your EMI can increase or decrease during the loan period.

How does it work?

When you choose a floating rate, the bank links your interest rate to the repo linked lending rate (RLLR) or marginal cost of funds-based lending rate (MCLR). As soon as the RBI decreases or increases the repo rate, your EMI also changes accordingly.

Advantages:

• If interest rates decrease, your EMI also decreases.
• Initially, floating rate is cheaper than fixed rate.
• There is a possibility of saving interest in the long run.

Disadvantages:

• There is uncertainty in EMI, which can make budget planning difficult.
• EMI can be very high if interest rates increase suddenly.
• Loan tenure can increase if EMI is kept the same.

Example : Suppose someone has taken a home loan of 20 lakhs at 8.5% floating rate. If RBI reduces the repo rate to 6%, then the interest rate can also come down to 7%. But if RBI reduces the repo rate to 7%, the interest rate can increase to 9%.

This interest rate is good for those whose income is likely to increase, like private sector employees or business people. It gives them an opportunity to take advantage of low interest rates, but there is also a risk of fluctuations in EMI.

3. Reducing Balance Interest Rate

What is it?

Reducing Balance Rate is the interest rate in which EMI is calculated on the decreasing principal amount every month. That is, after paying every EMI, the principal decreases and the next month’s interest is charged on the same reduced principal.

How does it work?

Suppose, you have taken a loan of 10 lakhs. After paying the first EMI, the principal will decrease a little. The interest of the second EMI will be charged on the newly reduced principal. In this way, your interest keeps decreasing over time and the loan gets repaid quickly.

Advantages:

• Interest is charged only on the remaining principal, due to which the total interest has to be paid less.
• It proves to be economical for the borrower in the long run.
• Gradually the interest part in EMI decreases and the principal part increases.

Disadvantages:

• The initial EMI may be a little higher.
• Understanding the EMI structure can be difficult for new borrowers.
• Some banks may have higher processing fees or hidden charges.

Example : Most banks follow the reducing balance method for home loans and personal loans. For example, taking a loan of Rs 10 lakh at 8% reducing balance rate results in lower total interest than a fixed rate loan.

This interest rate is best for those who take a large loan for a long period. This saves on interest and repayment is faster.

4. Simple Interest Rate

What is it?

Simple Interest Rate is the interest rate in which interest is charged only on the principal, not on the previously added interest. It is often used in short-term loans, education loans or small borrowings.

How does it work?

Simple Interest is calculated as (Principal × Rate × Time) ÷ 100. Suppose 1 lakh rupees is taken at 10% simple interest for 1 year, then the interest will be only Rs 10,000.

Advantages:

• The calculation is easy and transparent.
• The borrower knows how much interest he will have to pay.
• It is economical for short-term loans.

Disadvantages:

• The borrower does not get much benefit in long-term loans.
• There is a lack of compounding benefit.
• EMI repayment structure is not flexible.

Example : Many microfinance loans or short-term agriculture loans are given using simple interest methods.

This interest rate is suitable for those who need a loan for a short period and want a clear calculation of repayment.

5. Compound Interest Rate

What is it?

Compound Interest Rate is one in which interest is charged on the principal as well as on the previously added interest. That is, the concept of “interest on interest” applies.

How does it work?

Suppose, Rs 1 lakh is taken annually at 10% compound interest. After the first year, the interest will be Rs 10,000, which will make the amount Rs 1,10,000. Next year interest will be charged on Rs 1,10,000 i.e. Rs 11,000.

Advantages:

• The lender gets higher return due to compounding effects.
• In short-term loans, the borrower does not make much difference.
• Banking and credit card interest is based on this.

Disadvantages:

• In the long run, the borrower may have to pay a lot of interest.
• Loans can be expensive if repayment is not done on time.
• Interest calculation may seem complicated for the borrower.

Example : Credit card dues and overdraft facilities are based on compound interest rates.

This interest rate is beneficial for the lender. Borrowers should always repay the loan taken at compound rate on time, otherwise the debt can increase rapidly.

6. Prime Lending Rate (PLR) – (Prime Lending Rate)

What is it?

Prime Lending Rate (PLR) is the minimum interest rate at which the bank gives loans to its most trusted and creditworthy customers. It works like base rate.

How does it work?

Banks decide PLR ​​by looking at RBI’s monetary policy and their cost of funds. Customers with good credit scores and strong repayment capacity get loans at PLR. Other borrowers are given loans at rates above PLR.

Advantages:

• Borrowers with high credit scores get loans at lower interest rates.
• Loan rates are transparent and RBI linked.
• PLR is a benchmark for creditworthy borrowers.

Disadvantages:

• Average borrowers do not get loans at PLR.
• Changes in PLR depend on RBI’s policy.
• The actual loan rate for common borrowers is higher.

Example : Top corporates and big companies get working capital loans and term loans at PLR.

This rate is more useful for high-profile borrowers and corporations. Common borrowers usually have to take loans at rates above PLR.

7. Discount Interest Rate

What is it?

Discount Interest Rate is the rate at which commercial banks do short-term borrowing from RBI. It mainly applies to discounted bills of exchange and short-term securities.

How does it work?

This rate is applicable when RBI discounts commercial papers, treasury bills or promissory notes. It is a monetary tool of the RBI to control short-term liquidity.

Advantages:

• Helps to overcome short-term liquidity crunch.
• Maintains credit flow in the market.
• Regulates borrowing cost.

Disadvantages:

• Short-term borrowing becomes expensive when the rate is high.
• The general public does not get the benefit directly, it is relevant for banks.
• This rate is often dependent on market conditions.

Example: If a commercial bank suddenly needs short-term liquidity, it borrows from RBI at a discount rate.

Discount rate acts as a short-term liquidity stabilizer in the banking system. It does not directly affect borrowers, but indirectly affects loan rates and market liquidity.

8. Real vs Nominal Interest Rates 

What is it?

• Nominal Interest Rate – This is the rate in which inflation is not included.
• Real Interest Rate – It is derived by subtracting inflation from nominal interest rate.

How does it work?

Suppose nominal interest rate is 8% and inflation is 5%, then real interest rate will be only 3%. Real rate shows actual purchasing power and return.

Advantages:

• Nominal Rate Easy to understand and compare.
• Real Rate Shows real return and cost.

Disadvantages:

• The nominal rate is not inflation-adjusted, which can hide the actual benefit.
• Accurate inflation data is required to calculate the real rate.

Example: An FD gives 7% nominal interest. If inflation is 6%, then the actual return will be only 1%.

Investors and borrowers should always pay attention to the real rate, because it shows their real cost and real return.

9. Secured vs Unsecured Loan Interest Rates

What is it?

• Secured Loan Loans which are given against collateral (such as property, gold, FD).
• Unsecured Loan Loans which do not have any security, such as personal loan, credit card loan.

How does it work?

If there is collateral, the risk to the bank is reduced, so the interest rate on secured loan is low. Whereas in unsecured loans, the rate is high due to higher risk.

Advantages:

• Secured Loan Lower interest rate and higher loan amount.
• Unsecured Loan Fast approval and no need for collateral.

Disadvantages:

• Risk of losing assets on defaulting on secured loans.
• High interest rate and short repayment period in unsecured loans.

Example:

• Home loan and car loan are secured.
• Personal loan and credit card loans are unsecured.

Secured loans are cheaper for borrowers, but there is collateral risk. On the other hand, unsecured loans are expensive but prove useful in an emergency.

10. Penalty Interest Rate – (Penalty Interest Rate)

What is it?

Penalty Interest Rate is the additional interest that is charged in case of delay or default of loan EMI.

How does it work?

If the borrower does not repay on time, a penalty rate is charged over and above the normal interest rate. This rate may vary according to the terms & conditions of the banks.

Advantages:

• Makes borrowers disciplined for timely repayment.
• Helps banks cover default risk.

Disadvantages:

• The financial burden on borrowers increases.
• High penalty rates can put borrowers in a debt trap.

Example : The EMI of a personal loan is Rs. 10,000 and the borrower delays. The bank can charge an extra 2% per month penalty rate on it.

Penalty rate is a harsh financial cost for borrowers. The best way to avoid it is by repaying on time.

Read Also: How Interest Rate Changes Affect the Stock Market

How to Choose the Right Type of Interest Rate?

1. Look at the stability of income : If the income is stable and EMI can be paid comfortably every month, then fixed rate proves to be better. But for those whose income is variable, like people working in business or commission-based jobs, floating rate is more practical.
2. Importance of Loan Tenure : For short-term loans i.e. 1 to 5 years, floating rate is a good option, because short-term fluctuations remain manageable. On the other hand, for long-term loans i.e. 10 to 20 years, fixed rate keeps EMI stable and financial planning becomes easy.
3. Effect of Inflation : If inflation is expected to increase in the coming time, then fixed rate keeps EMI stable. On the other hand, in case of inflation decreasing, floating rate benefits the borrowers, because interest rates can come down.
4. Risk Appetite : For conservative borrowers, fixed rate is better, so that EMI remains predictable. Floating rate is good for those whose risk-taking capacity is moderate or high, so that they can get the benefit of low interest rate.
5. Purpose of Loan : Fixed rate provides more stability for home loan and education loan. Floating rate is more suitable for working capital or business loans because it provides cash flow flexibility. In case of investment-linked loans, one should choose after understanding the real interest rate and compound effect.
6. Practical Checklist : Before taking a loan, it is important to think about how much percentage of income EMI is manageable, for how long the loan has to be taken, how much impact will inflation and RBI policy changes have on EMI, what will be the long-term difference between fixed and floating and what will be the penalty charges or foreclosure rules.

Read Also: Types of Investment in the Stock Market

Conclusion

It is important to understand the different types of interest rates as they determine your loan cost and financial planning. Choosing the right interest rate depends on your income, loan tenure and market conditions. A wise decision not only makes EMI management easier but also ensures financial stability in the long term.

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