If you have applied for a personal loan, it is only likely that you are familiar with the concept of interest rates. However, despite having the basic familiarity, many borrowers grapple with calculations, failing to figure out why these rates are different for different customers, and sometimes exorbitant. Credit card transactions are known to entail exorbitant rates if the entire outstanding amount isn t cleared before the interest-free period. Interest rates on personal loans can be exorbitant too at times. If you want to figure out why exactly personal loans sometimes attract exorbitant interest rates, here s everything you need to know.
Flat and Effective Interest Rates- What s the Difference?
You must have seen advertisements from P2P/Fintech Lenders claiming to offer loans at rates as low as 8%. But while the idea might seem tempting, it s far from reality. Why so, you may ask? Well, it s because the advertised rates are flat rates that do not indicate the actual amount you re required to repay. A flat rate of 10% can translate to 15% to 20% under the effective rate structure (the effective rate, also known as the reducing balance rate, is the real interest rate that lenders use to compute interest on loans they offer).
However, what are these flat and effective rates and how do they work? For starters, the flat rate is a fixed interest rate that doesn t consider the tenure of your loan or the amount you repay every month. So, if you take a loan of Rs 1,00,000 for 5 years at a flat rate of 12%, you will be required to pay 12% interest for the entire amount. The annual interest on your loan will be Rs 12,000, but 12,000 isn t the real interest that you d end up paying. Still, some lenders continue to advertise these rates to dupe unsuspecting customers into their lending trap.
Contrary to the flat rate, effective interest rate (also known as reducing interest rate) will consider the tenure of your loan and the instalments you pay every month. Since it is not fixed, it will be constantly adjusted against the outstanding balance of your loan. So, unlike flat rates where you have to pay a fixed interest rate against the principal loan amount, here you will only have to pay an interest against the remaining loan balance.
So if you ve been paying high interest rates and are wondering why that s the case, chances are you re paying a flat interest rate which (at times) is twice the effective interest rate.
The Role of Risk-Based Pricing in determining interest rates on loan applications
In the credit market, risk-based pricing refers to the concept of offering varying interest rates to varying customers according to their creditworthiness. This pricing will consider factors like your credit score, bad credit history, status of employment and income level. Since the credit profile and income level of consumers tend to vary, everyone is not eligible for the same interest rate. This means that if your credit indicators aren t strong enough, you might be offered a much higher rate of interest on your loan.
Why is your Credit Score Important?
While your accrued interest can be higher because of flat rates, poor credit score is another pertinent reason. Your credit score is a number that is decided according to your credit report. Since this report offers a detailed insight about your borrowings and debt history, your score will be high if you pay your dues on time. But if that s not the case, there is a high possibility for you to have a low credit score. While Fintechs offer loans to low credit score holders, you need to have a score of at least 575-600 to qualify for a loan. Also, the lesser your score is, the higher the interest rate on your loan. So, if you do have a poor credit score, it s time to pull up your socks, consolidate your debts and pay your bills on time to get a good interest rate.
(By Aditya Kumar, Founder & CEO, Qbera.com)