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Understanding different types of interest rates and how they are calculated

Understanding different types of interest rates and how they are calculated

Interest rates differ based on how they are set and how interest is calculated. Common types include fixed, floating, hybrid, repo-linked, MCLR-linked, simple, compound, flat, and reducing balance rates. Understanding how each works can help borrowers compare EMIs, total borrowing costs, and repayment structures. Factors such as benchmarks, calculation methods, compounding, and APR can significantly affect the actual cost of a loan.

The main types of interest rate differ in two ways: how the rate is set and how interest is calculated. A rate may be fixed, floating, or linked to a benchmark such as the repo rate. Separately, interest may use the simple, compound, flat, or reducing balance method. Both choices affect the EMI and total borrowing cost. This guide explains the different types of interest rates in India and helps you compare their costs clearly before selecting a borrowing product.

The types of interest rates on loans show how a rate is set and how interest is calculated.

Types of interest rates at a glance

So, how many types of interest rates are there? The table below covers nine common categories.

BasisTypeMeaning
Rate settingFixedRemains constant
FloatingFollows a benchmark
Hybrid/dualFixed, then floating
Repo-linked/External Benchmark Lending Rate (EBLR)Follows approved external benchmark (usually repo rate)
Marginal Cost of Funds-Based Lending Rate (MCLR)Follows bank’s internal benchmark
CalculationSimpleCalculated on principal only
CompoundCalculated on principal plus accrued interest
FlatCalculated based on the original principal
Reducing balanceCalculated based on the outstanding principal

Fixed vs floating interest rate

Fixed rates offer predictable EMIs, but may start higher and include prepayment charges. On the other hand, floating rates track a benchmark which affects the EMI or tenure.

RBI directions bar prepayment charges for floating, non-business individual loans sanctioned or renewed from January 1, 2026. Fixed-rate charges depend on the contract. For borrowers who want a middle path, a hybrid interest rate starts fixed, then floats.

Choosing between fixed, floating, and hybrid interest rates depends on how much uncertainty in EMIs and tenure you are comfortable with. Different types of interest rates suit individuals with various levels of risk tolerance, so it’s always wise to compare the types of interest rates on loans and check the relevant benchmark before making a decision.

Repo-linked and EBLR rates: How floating rates work in India

Since October 2019, RBI has required banks to link new floating-rate retail loans to an external benchmark under the EBLR framework. The different types of interest rates in India under EBLR can track various benchmarks like the repo rate (repo-linked rate), specified Treasury bill yields, or another approved benchmark.

The total interest rate on a floating loan equals the benchmark plus the lender’s spread, and resets at least every three months. For instance, the present repo rate is 5.25% as of August 5, 2026. If the RBI changes the repo rate later, the revised rate must be reflected in eligible EBLR-linked loans within the three-month reset cycle.

EBLR transmits policy changes faster than MCLR, which is an internal lending benchmark based on a bank’s marginal cost of funds, and only applies to some older loans. The types of interest rate risks for an MCLR-linked loan include a higher EMI or longer tenure when the benchmark rises.

Simple vs compound interest

While simple interest uses principal only, compound interest also uses accumulated interest.

Here’s an example of how these two different types of interest rates work: At 10% over two years, ₹1 lakh incurs ₹20,000 simple interest or ₹21,000 with annual compounding.

Simple interest usually appears in some short-tenure products, while compounding is more common in investments and long loans.

Flat vs reducing balance interest

With a flat rate, interest is calculated on the full loan amount throughout the tenure, even as you repay it. On the other hand, with a reducing rate, interest is calculated only on the amount you still owe.

Therefore, when comparing types of interest rates on loans, it’s so important to check the total repayment amount, as two loans quoting the same interest rate can have different costs depending on whether they use the flat or reducing balance method.

Nominal vs effective interest rate (and APR)

The nominal interest rate is the stated rate, without accounting for compounding or fees, excluding compounding and fees. On the other hand, the effective rate includes compounding. What this means is that if a 12% nominal rate is compounded monthly, after interest is added every month, the effective annual rate increases to approximately 12.68%.

The Annual Percentage Rate (APR) combines loan interest and associated charges. RBI requires its computation in the Key Facts Statement before a retail term-loan contract is executed. When comparing types of loans and interest rates, use APR because a low flat rate may conceal a high effective cost.

Which type of loan has the highest interest rate?

Secured home, gold, and auto loans cost less because the collateral reduces risk. Unsecured personal loans cost more, while revolving credit-card debt and informal or dealer flat-rate finance are often the most expensive.

However, always remember that your interest rate is also highly dependent on your borrowing profile and chosen lender.

Conclusion

Understanding the various types of interest rates requires checking rate setting and calculation. When you understand the various terms related to loans and know how to compare them based on APR, you become empowered to choose the right credit option for your needs. For a smooth loan application process, explore a Tata Capital Personal Loan.

Do note that the rates, benchmarks, and terms may change at the RBI’s or lender’s discretion. All this is general information only, and it is essential to always compare the different types of interest rates available in India before choosing.

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FAQs

What are the different types of interest rates?

The different types of interest rates include fixed, floating, hybrid, repo-linked, MCLR-linked, simple, compound, flat, and reducing rates.

What is the difference between fixed and floating interest rates?

While fixed interest rates stay constant, floating interest rates follow a benchmark and may change the repayment amount with fluctuations.

What is a repo-linked or EBLR interest rate?

An EBLR interest rate follows an approved external benchmark, and is commonly repo-linked since it follows the RBI’s repo rate.

What is the difference between flat and reducing interest rates?

These two types of interest rates differ based on their calculation base: a flat rate uses the original principal, while a reducing rate uses the outstanding balance.

What is the difference between nominal and effective interest rates?

Nominal is the quoted rate. Comparing types of loans and interest rates requires the effective rate or APR, as these reflect the compounding and charges.

Which type of loan has the highest interest rate?

Revolving credit-card debt and informal flat-rate finance are typically the costliest loans, subject to the borrower, lender, tenure, and fees.

How many types of interest rates are there?

There are nine common types of interest rates in India, divided based on their setting and calculation methods.
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