How is the total interest on a personal loan calculated?

One of the key aspects that borrowers need to understand about taking out a personal loan is how the interest is calculated and the total amount they'll end up paying over the loan tenure.

When you borrow money through a personal loan, you agree to repay the principal amount along with interest over a specified period. The interest is essentially the cost of borrowing and is typically expressed as an annual percentage rate (APR). Understanding how this interest is calculated can help you make informed decisions about your loan and potentially save money in the long run.

FIRSTmoney personal loans explained
 

IDFC FIRST Bank's FIRSTmoney smart personal loan offers a unique approach to personal interest calculation. Unlike traditional personal loans where you borrow a lump sum and pay interest on the entire amount from day one, FIRSTmoney allows for more flexibility.

With minimal documentation and a simple application process, FIRSTmoney offers one of the most competitive interest rates and the flexibility to withdraw funds unlimited times as and when needed. This smart personal loan offers a high loan offer of up to Rs.10 lakh that you can withdraw in one go or trenches, and you only pay interest on the amount you actually use. This means that you do not need to apply for a new loan when you need extra funds, you can simply withdraw funds from your loan offer as needed, in amounts of Rs. 5,000 or more, up to your available loan offer. Interest is then calculated only on the utilised amount instead of the total sanctioned amount. Additionally, you can opt for EMIs for tenures that can go up to 60 months and pre-close your loan anytime without incurring any foreclosure charges.

The interest calculation for FIRSTmoney uses the reducing balance method. This means that as you repay your loan through EMIs, the interest component of your EMI decreases over time, while the principal component increases. This method generally results in lower total personal loan interest rates compared to the flat rate method.

The basic formula for calculating EMI is -

EMI = P x R x (1+R)^N / [(1+R)^N-1]
 

Where:

P = Principal loan amount

R = Monthly interest rate (annual rate divided by 12 months)

N = Total number of monthly instalments

Factors affecting total interest
 

• Generally, the larger the loan amount, the more interest you'll pay in total. However, with FIRSTmoney's flexible withdrawal feature, you can potentially reduce your interest by only borrowing what you need when you need it.
• The longer the loan tenure, the more interest you'll pay overall. While longer tenures result in lower monthly EMIs, this also means you'll be paying interest for a longer period.
• Higher interest rates naturally lead to more total interest paid over the life of the loan. FIRSTmoney offers competitive rates starting from 10.99% p.a. for eligible borrowers.
• With FIRSTmoney, you have flexible repayment options. Choosing a shorter repayment period or making extra payments can reduce the total interest paid.
• While not directly affecting the interest calculation, your credit score influences the interest rate you are offered. A higher credit score (730+ for FIRSTmoney) can lead to more favourable rates and thus lower total interest.

Let's walk through some example calculations to illustrate how the total interest is determined using FIRSTmoney's loan product.

Assume you're approved for a FIRSTmoney loan offer of Rs. 5,00,000 at an interest rate of 10.99% p.a. for a tenure of 36 months. You decide to withdraw the full amount immediately.

Using the EMI formula:
 

EMI = 500000 x (0.1099/12) x (1+0.1099/12)^36 / [(1+0.1099/12)^36-1]

EMI ≈ Rs.16,367

Over 36 months, you'll pay a total of 16,367 x 36 = Rs.589,212

Total interest paid = Rs.589,212 - Rs.500,000 = Rs.89,212

Now, let's say you only need Rs.2,00,000 initially. You withdraw this amount and start repaying it over 36 months at 10.99% p.a.

EMI = 200000 x (0.1099/12) x (1+0.1099/12)^36 / [(1+0.1099/12)^36-1]

EMI ≈ Rs.6,547

Total amount paid over 36 months = 6,547 x 36 = Rs.235,692

Total interest paid = Rs.235,692 - Rs.200,000 = Rs.35,692

As you can see, by utilising only part of your loan offer, you've significantly reduced the total interest paid.

Benefits of understanding interest calculations
 

By grasping how interest is calculated on your personal loan, you can -
 

• Make more informed borrowing decisions
• Compare different loan offers more effectively
• Plan your repayment strategy to minimise total interest paid
• Understand the impact of extra payments or early repayment

Understanding the mechanics of interest calculation on personal loans, particularly flexible products like FIRSTmoney, can empower you to make smarter financial decisions. Leveraging features such as multiple loans: anytime, anywhere or multiple on-demand loans and paying interest only on the utilised amount help you potentially reduce your overall borrowing costs while meeting your financial needs effectively.