Interest payable on loan outstanding

Understanding Interest: Types and Calculation

Interest can be broadly categorized into two main types:

• Simple Interest: Calculated only on the principal amount. The formula is: Simple Interest = (P x R x T) / 100, where P = Principal, R = Rate of Interest, and T = Time.
• Compound Interest: Calculated on the principal amount and also on the accumulated interest of previous periods. This leads to exponential growth of the interest payable. The formula is: A = P (1 + R/n)^(nt), where A = Future Value, P = Principal, R = Annual Interest Rate, n = Number of times interest is compounded per year, and t = Number of years.

Interest Rate Methodologies

Loans are typically offered with one of the following interest rate methodologies:

• Fixed Interest Rate: The interest rate remains constant throughout the loan tenure, providing predictability for borrowers.
• Floating (or Variable) Interest Rate: The interest rate fluctuates based on a benchmark rate (e.g., Marginal Cost of Funds based Lending Rate - MCLR, Repo Rate) plus a spread. This exposes borrowers to interest rate risk but can also benefit them if rates fall.
• Hybrid Interest Rate: A combination of fixed and floating rates, often fixed for an initial period and then linked to a benchmark rate.

Compounding Frequency and its Impact

The frequency of compounding significantly impacts the total interest payable. More frequent compounding (e.g., monthly vs. annually) results in a higher effective interest rate, even if the nominal interest rate is the same. This is due to the interest earned being added to the principal more often, leading to interest on interest more frequently.

Regulatory Framework – The Role of the RBI

The Reserve Bank of India (RBI) plays a crucial role in regulating interest rates and ensuring fair lending practices. Key regulations include:

• Base Rate System (abolished in 2015): Previously, banks were required to set a base rate below which lending could not occur.
• Marginal Cost of Funds based Lending Rate (MCLR) (introduced in 2016): Banks now price loans based on the cost of funds, ensuring greater transparency and responsiveness to market conditions.
• External Benchmark Lending Rate (EBLR) (introduced in 2019): Banks are encouraged to link lending rates to an external benchmark like the Repo rate, further enhancing transparency and efficiency.
• Interest Rate Deregulation: The RBI has largely deregulated interest rates on most loans, allowing banks to determine rates based on their risk assessment and market conditions. However, it monitors lending practices to prevent usurious rates.

Implications for Borrowers and Lenders

For Borrowers: Understanding the type of interest rate, compounding frequency, and associated fees is crucial for making informed borrowing decisions. Floating rates offer potential savings if rates fall, but also carry the risk of increased payments if rates rise. For Lenders: Interest rates are a primary source of revenue. They must balance the need for profitability with the risk of default and the regulatory requirements set by the RBI. Risk-based pricing is common, where higher-risk borrowers are charged higher interest rates.

Recent Developments

The adoption of the Repo-linked lending rate has become increasingly prevalent post-2019, as mandated by the RBI. This has led to faster transmission of monetary policy changes to borrowers. Furthermore, the RBI’s focus on improving financial literacy is aimed at empowering borrowers to understand the complexities of loan interest calculations.