If you’re a first-time borrower, you may have heard about the different ways lenders calculate interest rates for a business loan, or you may not have. That’s ok, you’re not alone! So, we’re here to help you learn a little about the borrowing process and the kinds of interest rates lenders will offer you.
Remember, when you get any kind of loan, there are two amounts you need to pay the lender:
- The principal amount – This is the original sum you borrow from a lender.
- The interest amount – This is the extra amount your lender charges in exchange for giving you the loan. Most lenders calculate interest as an annual percentage rate (APR) that you pay per year. The interest rates a lender offers you depends on numerous factors including:
- What type of business loan you need – Unsecured business loan, secured business loan, loan against property, etc.
- What sector you operate in.
- How old your business is (also known as business vintage).
- What your annual turnover is.
- What your credit score is.
- The duration of the loan.
- What collateral you offer the lender.
Borrowers usually repay their loans in monthly instalments. The monthly instalments are called your Equated Monthly Instalment (EMI).
For example, if you want a loan of Rs. 1,00,000 for a tenure of 1 year (or 12 months), and the lender offers you an interest rate of 10.5%, your EMI will be Rs. 8,815.
At the end of the loan tenure (1 year), you would have repaid the lender Rs. 1,05,778 which includes the principal amount (Rs. 1,00,000) and the interest amount (Rs. 5,778).
Now let’s learn a little more about your interest rate options!
What are the two types of EMI interest rates the lender may offer me?
- Fixed interest rate
- Reducing interest rate
What is a fixed interest rate?
A fixed (also called flat) interest rate is one where the lending interest rate remains the same throughout the tenure of your loan. This means the interest rate for the entire loan tenure will be calculated at the time when you get the loan itself.
How is a fixed interest EMI calculated?
(Loan principal amount x total tenure of the loan x interest rate per annum)/total number of instalments = Interest to be paid with each instalment
What is a reducing interest rate?
Unlike a fixed interest rate, a reducing (or diminishing) interest rate is calculated on the outstanding principal amount.
For example, if you took a loan for Rs. 1,00,000 and have already repaid off Rs. 20,000 of the principal amount, the interest of your next EMI will be calculated on the principal amount of Rs. 80,0000 instead of Rs. 1,00,000.
How is a reducing interest EMI calculated?
Outstanding loan amount x interest rate for each instalment = EMI
What is the difference between fixed and reducing interest EMIs?
- Fixed interest is calculated on the original loan amount, while the base for calculation of the reducing interest keeps changing over time as you repay your loan.
- For the fixed interest option, you know at the time of loan disbursement exactly how much you will owe the lender each month, and this amount will be the same every time. Therefore, this makes financial planning easier for you.
- Lenders usually offer slightly lower rates for fixed interest when compared to reducing interest rates.
- Lenders may offer a longer loan tenure for a fixed interest loan than for a reducing interest loan.
Should I choose the fixed or the reducing interest EMI option?
Both fixed and reducing interest rates offer borrowers different benefits, and you should make this decision based on your financial needs and repayment capacity.
A reducing interest EMI will have a shorter loan tenure and lower EMIs over time. However, a fixed interest rate will offer you a longer loan tenure and a lower interest rate, but the EMI amounts remain the same, month on month.
At CreditEnable, we recommend our SME borrowers take either type of ROI because the amount of interest you end up paying with both balances out over time. The fixed interest may sound attractive at first as it is a lower amount, but as you start repaying the loan, the amount you pay as reducing interest also starts becoming a smaller value.
Have other questions about interest rates? We answered them here!