How To Calculate Interest Rates – Step-by-Step Guide

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Types of interest rates:

• Fixed interest rate
• Floating interest rate 
• Simple interest rate 
• Compound interest rate 

Let's understand these interest rates in detail. 

What are the types of interest rates?

If you borrow money, you have to pay interest on it. Similarly, when you invest money somewhere, you get interest from it. Let's understand how it works. 

Fixed interest rate

A fixed interest rate is the same for the whole period. It remains the same throughout the loan. If there is any market change, your interest rate is going to be the same. 

Benefits of the fixed interest rate:

• You can predict monthly payments
• Your budgeting and financial planning will be better with a fixed interest rate. 
• Protection from future interest rate increases

Floating interest rate 

A floating interest rate is the opposite of a fixed interest rate. You may know that the repo rate changes often. When the repo rate changes, banks also change their interest rates. That's why it's called a floating interest rate. 

Advantages of floating interest rate:

• You can take floating interest rates at lower rates than fixed interest rates.
• If the market goes down, your interest rate can also decrease.
• You can close floating interest rates with no penalty; many lenders can allow this.

Disadvantages of floating interest rate

• Your EMI amount can change when there is fluctuation in the market.
• If the interest rate rises, your EMI can also increase. 

Simple interest rate 

Simple interest rate is calculated on only the principal amount. Here, the interest amount remains the same for the whole period. Simple interest is calculated with the formula:

Simple interest = P*R*T/100

Here, 

P = Principal (original amount)

R = Annual interest rate

T = Time period in years

Compound interest rate 

Compound interest is calculated on both the principal and the interest you already earned. That's why compound interest is also called interest on interest. Your money grows faster here. Compound interest is calculated with this formula:

CI = P (1+r/n)^nt - P

Here,

P = Principal (initial amount invested or borrowed)

r = Annual interest rate

n = Number of times interest is compounded each year

t = Time period in years

What is an example?

Raghav is thinking about investing  ₹1,00,000 for 5 years at an interest rate of 8% per year. Let's understand how much he can earn with different interest rates.

If he invests with simple interest,

SI = P*R*T/100

    = ₹1,00,000*8*5/100

    = ₹40,000

That means, if Raghav invests money with simple interest, he will earn ₹40,000 after 5 years. 

If he invests in compound interest 

CI = P (1+r/n)^nt - P

     = ₹1,00,000 ( 1 + 8/100)^5

     = 1,46,933

That means, if Raghav invests money with simple interest, he will earn ₹46,933 after 5 years. 

Conclusion

Interest rate is used in banks and markets. Before taking a loan or investment money somewhere, you need to understand how interest rates work. If you have an idea about interest rates, you can choose a better option for yourself, which will help you earn more interest. 

There are four types of interest: fixed interest, floating interest, simple interest, and compound interest. All the interests work differently. You can check how the interest rate is calculated and how it gives you a better interest rate. 

Frequently asked questions 

Can a floating interest rate become lower than a fixed interest rate?

When you go for a floating interest rate, banks or markets offer it lower than the fixed interest rate. But if in the future the RBI changes its repo rate and decreases it, market interest rates are also going to be decreased. 

Which is better: simple interest or compound interest?

It wholly depends on the purpose. If you want to borrow money from a bank, you can go for simple interest. Because the interest here is only on the principal amount, it becomes a little less than compound interest. And if you want to invest money somewhere, you can go for compound interest so that your money will grow faster.

How is compound interest calculated?

Compound interest is calculated on the principal amount and interest earned previously. That means if you invest 100 at 10% interest. You will get 110 in the first year and 121 in the second year, because in the second year interest is calculated on 100 and 10. 

How is simple interest calculated?

Simple interest is calculated on only the principal amount. If you invest 100 with a 10% interest rate. You will get 10 every year.

In India, who decides interest rates?

In India the Reserve Bank of India decides the repo rate and banks change their interest rate according to it. 

What is an interest rate?

An interest rate is the percentage that is calculated on the principal amount when you invest money or borrow money. 

Why do banks offer floating interest rates on loans?

The market is not stable; it keeps changing. RBI changes the repo rate, and it affects banks' interest rates too. If banks give loans at lower interest rates and in the future the RBI increases the repo rate, it will negatively affect banks. That's why banks offer floating interest rates so that interest rates change with market conditions.

What factors influence interest rates in India?

Interest rates in India are decided based on the economic conditions in the market and Borrower's finance situation. Policy rates, inflation, credit score, income, and repayment history are major eliminations that affect interest rates. 

Why is it important to understand interest rates before taking a loan?

You need to know about your interest rate before taking a loan because it affects your monthly EMI. That means it decides how much you will pay each month.