When you apply for a loan in India—whether it’s a home loan, personal loan, or car loan—the most important factor to consider is the interest rate. It determines how much you’ll repay over time, beyond the principal amount. But how are loan interest rates actually calculated in India?
This guide breaks it down in simple terms.
Types of Interest Rates on Loans in India
Banks and NBFCs (Non-Banking Financial Companies) use different methods to calculate interest:
1. Fixed Interest Rate
- The rate stays the same throughout the loan tenure.
- EMI remains constant.
- Best for short-term loans where interest rate fluctuations don’t matter.
2. Floating Interest Rate
- Linked to a benchmark (like the RBI repo rate).
- Changes with market conditions.
- EMIs may increase or decrease during the loan period.
3. Reducing Balance Method (most common)
- Interest is calculated on the outstanding principal after each EMI.
- As your principal reduces, the interest portion decreases and EMI covers more principal.
4. Flat Interest Rate
- Interest is charged on the entire loan amount, regardless of repayment.
- Often used in vehicle loans and consumer durable loans.
- More expensive compared to reducing balance method.
Key Factors That Decide Your Loan Interest Rate
Banks don’t offer the same rate to everyone. Your rate depends on:
- Credit Score – Higher scores (750+) mean better rates.
- Income Level – Higher income lowers risk, leading to lower interest.
- Type of Loan – Home loans usually have lower rates than personal loans.
- Loan Tenure – Longer tenures may come with slightly higher rates.
- Lender Policies – Each bank follows its own guidelines.
How Banks Calculate EMI (with Formula)
The most common formula for EMI (Equated Monthly Installment) is:
EMI = [P × R × (1+R)^N] / [(1+R)^N – 1]
Where:
- P = Loan principal
- R = Monthly interest rate (annual rate ÷ 12 ÷ 100)
- N = Number of monthly installments
✅ Example: If you take a loan of ₹5,00,000 at 10% annual interest for 5 years (60 months):
- P = 5,00,000
- R = 10% ÷ 12 = 0.0083
- N = 60
- EMI ≈ ₹10,624
Practical Tips to Get a Lower Interest Rate
- Maintain a good credit score (above 750).
- Compare offers from multiple banks before applying.
- Go for shorter tenures if possible.
- Use a loan EMI calculator to plan better.
- Negotiate with your bank if you have a long-term relationship.
Final Word
Interest rates in India are calculated differently depending on whether the loan uses fixed, floating, reducing balance, or flat-rate methods. Most major loans today follow the reducing balance method, which is fairer to borrowers. Understanding how rates are set—and the factors that affect them—can help you choose the best loan and save money over time.