How Personal Loan Interest Rates Are Calculated

When considering a personal loan, one of the most important factors to understand is the interest rate. The interest rate determines how much you will ultimately pay back to the lender in addition to the amount borrowed. However, many people are unclear on how these rates are calculated and why they vary from one person to another. In this article, we’ll break down the various factors that affect personal loan interest rates, how lenders calculate them, and what you can do to get the best rate.

What Is a Personal Loan?

A personal loan is a type of unsecured loan provided by banks, NBFCs (Non-Banking Financial Companies), or online lenders. It is typically used for purposes such as medical expenses, home renovation, travel, debt consolidation, weddings, or emergencies. Since personal loans are unsecured, meaning they don’t require any collateral, the interest rates tend to be higher compared to secured loans like home or car loans.

What Is an Interest Rate?

The interest rate is the cost of borrowing money. It is expressed as a percentage of the loan amount and is charged annually. For example, if you borrow ₹1,00,000 at an annual interest rate of 12%, you will pay ₹12,000 in interest in one year (excluding principal repayments and other fees).

Types of Interest Rates on Personal Loans

There are mainly two types of interest rate structures used for personal loans:

Flat Interest Rate
In this method, the interest is calculated on the entire principal amount throughout the loan tenure, regardless of how much you’ve repaid.

Example: If you borrow ₹1,00,000 at a flat rate of 10% for 2 years, interest will be ₹10,000 every year, even though your outstanding balance decreases.
Reducing (Diminishing) Balance Interest Rate
Here, the interest is charged only on the outstanding loan balance, which reduces as you repay the loan monthly. This is a more cost-effective method for borrowers.

Example: If your loan is ₹1,00,000 at 10% reducing rate, the interest amount will decrease each month as the principal gets repaid.

Note: A reducing interest rate of 10% is roughly equivalent to a flat rate of 6.5%–7% when calculated annually.

Factors That Influence Personal Loan Interest Rates

Lenders consider several factors while determining the interest rate applicable to a borrower. Here are the key ones:

1. Credit Score (CIBIL Score)

Your credit score reflects your creditworthiness and repayment history. Most lenders in India use CIBIL scores, ranging from 300 to 900. A higher score (750 or above) can help you secure lower interest rates.

Excellent Credit (750–900): Lower interest rate (e.g., 10%–12%)
Average Credit (650–749): Moderate interest rate (e.g., 13%–16%)
Poor Credit (<650): Higher interest rate or loan rejection

2. Income Level

Lenders assess your monthly or annual income to determine your ability to repay the loan. Salaried individuals working in reputed companies or government jobs often get better rates compared to self-employed professionals with irregular incomes.

3. Employment Stability

A stable employment history is a sign of financial security. Lenders typically prefer applicants who have been with the same employer for at least 1–2 years.

4. Loan Amount and Tenure

Higher loan amounts might attract lower rates in some cases due to negotiation leverage, especially with banks. However, longer loan tenures may increase the overall interest payout even if monthly EMIs are smaller.

5. Relationship with the Lender

Existing customers of a bank or NBFC—especially those with salary accounts or previous loans—may be eligible for preferential rates.

6. Market Conditions and RBI Policy

Interest rates in the economy are also influenced by RBI’s repo rate (the rate at which banks borrow from the RBI). When the repo rate is low, personal loan interest rates may also reduce.

How Lenders Calculate EMI Based on Interest Rate

Once the interest rate is decided, the EMI (Equated Monthly Instalment) is calculated using this formula for reducing balance loans:

\frac{P \times R \times (1+R)^N}{(1+R)^N - 1}

Where:

P = Principal loan amount
R = Monthly interest rate (Annual rate divided by 12 × 100)
N = Loan tenure in months

Example:
Loan Amount: ₹2,00,000
Interest Rate: 12% annually (1% per month)
Tenure: 24 months

\frac{200000 \times 0.01 \times (1+0.01)^{24}}{(1+0.01)^{24} - 1} = ₹9,415 (approx.)

The total amount payable over 2 years would be ₹9,415 × 24 = ₹2,25,960, which includes ₹25,960 as interest.

Fixed vs Floating Interest Rates

Some lenders offer floating interest rates that can change based on market fluctuations, while others offer fixed rates that remain constant throughout the loan term.

Fixed Rate Loans: Safer and predictable. Ideal in a rising rate environment.
Floating Rate Loans: May become cheaper if market rates fall, but carry risk.

Tips to Get the Best Personal Loan Interest Rate

Check Your Credit Report Regularly
Ensure there are no errors and maintain a high score.
Compare Multiple Lenders
Use online loan aggregators to compare interest rates and processing fees.
Choose Shorter Tenure If Affordable
While EMIs may be higher, you’ll save on interest in the long run.
Negotiate with Your Bank
Leverage your relationship with your bank to get better rates, especially if you’re a loyal customer.
Avoid Multiple Loan Applications at Once
Each hard inquiry can affect your credit score.

Final Thoughts

Understanding how personal loan interest rates are calculated is key to making informed financial decisions. While some factors like market conditions are beyond your control, maintaining a healthy credit score, stable income, and good financial habits can help you qualify for lower interest rates. Always read the fine print, compare offers from different lenders, and calculate the total cost of the loan—including processing fees and prepayment charges—before signing on the dotted line.

If you’re considering taking a personal loan in Delhi NCR, platforms like Loan7d.com can help you compare and apply with leading banks and NBFCs to get the best deals based on your profile.