Interest rates 101: Explaining low and high interest rates on your loan

Banks charge interest rates for credit cards, car loans, personal loans, and business loans. Loan interest rates in the Philippines change based on the economy. If you plan on taking out a loan, it’s important to understand how loan interest rates work and their effect on loan costs.

Understanding loan interest rates

Interest rates are the amount charged on top of a borrowed money. It is usually calculated as a percentage of the total amount borrowed or loaned.

Simply put, a loan interest rate is the cost of debt for a borrower. It is an amount charged on top of the principal amount and is usually a percentage of the principal amount. Say for example you borrowed Php 10,000 from a friend and you agreed to a 5% loan interest rate. This means that you have to pay back an additional Php 500 on top of the principal amount of Php 10,000.

As interest rates directly affect the cost of loans, it plays a major part in the growth of an economy. Take, for example, how you can take out a bank loan to finance first-time homeownership. It is a big step up in life that you otherwise wouldn’t have achieved without significant funding. There are other loans that apply to car ownership, personal purchases like gadgets and electronics, and tuition. With all these immediate needs considered, a borrower agrees to pay for the amount of the purchase plus interest over a fixed period of time.

Banks use money from deposit accounts to fund or create loans. In return, banks receive interest payments from their borrowers.

The interest rate on a loan can make a big difference in how much you pay back over the life of the loan. Be sure to compare interest rates before you take out a loan.

The interest rate on a loan can also be affected by the type of loan that you choose. For example, the interest rate on a car loan is usually higher than the interest rate on a personal loan.

So, how do loan interest rates work

There are several factors that lenders consider when setting interest rates, including:

• Loan Term
• Loan Purpose
• Type of Loan

The interest rate you will receive is dependent on your loan term. For instance, the longer your loan term, the lower the interest rate you’ll get.

In the Philippines, there are different types of interest rates that lenders can charge:

Fixed Interest Rates

Fixed interest rates stay the same throughout the repayment period. You can manage your expenses better since your amortization will be fixed depending on your chosen rate fixing period.

Variable Interest Rates

Variable interest rates change over time based on economic conditions. This means that the interest rates can go up or down.

Annual Contractual Rate

The Annual Contractual Rate (ACR) is the interest rate computed based on the remaining balance per 360-day period.

Effective Interest Rate

An effective interest rate (EIR) is the rate of interest the bank earns from a loan in the span of a year. The EIR includes the interest rate and other fees related to the loan.

How interests affect your loan

Now that you understand how the interest rate is determined, let's take a look at how it is applied to your loan. The interest rate is usually expressed as an annual percentage, which is the amount of interest that will be paid on the loan each year.

The easiest way to understand how to compute bank loan interest rates in the Philippines is with an example. Let’s say you take out a personal loan with the following terms:

Loan amount: PHP 1,000,000
Loan term: 24 months
Monthly add-on rate: 1.50%
Monthly interest: 1,000,000 x 0.015% = 15,000
Monthly amortization: (1,000,000 ÷ 24) + 15,000 = 56,666.67

This means that you’ll be paying PHP 56,666.67 every month for two years to pay off the total loan amount.

Interest rates vary depending on a few factors, most notably: the economy, credit risk, and loan period. For example, a loan with a collateral is considered to have low risk since the bank can liquidate an asset to reclaim the lost amount. As an unsecured loan facility, this is typically the reason why personal loans have higher interest rates compared to car loans and home loans.

Furthermore, home loans and car loans are based on diminishing balance. This means that the monthly interest is computed based on the outstanding balance after each amortization. For example, if you take out a car loan with the following terms:

Loan amount: PHP 1,000,000
Loan term: 5 years
Interest rate: 10.56% per annum
Monthly Amortization: PHP 21,523.64

For the first monthly payment, PHP 12,844.18 goes to the principal while PHP 8,679.45 goes to the interest.

The effect of the interest rate on your loan is reflected on the total amount and the monthly payments you make. The interest that you pay each month depends on the loan’s outstanding balance. At the beginning of the term, when the balance is higher, you pay more interest. Over time, interest paid significantly goes down as the principal loan amount also decreases.

The Impact of Interest Rates on the Economy

Interest rates can have a significant impact on the economy. When interest rates rise, it becomes more expensive for people to borrow money, which can lead to a slowdown in economic growth. On the other hand, when interest rates fall, it becomes easier for people to borrow money, which can lead to increased economic activity.

What is a good loan interest rate in the Philippines?

If your interest rate is a variable interest rate, it can be affected by the prevailing market rate. If the market rate goes up, the lender may raise their interest rates as well. If the market rate goes down, the lender may lower their interest rates. Fixed interest rates, on the other hand, won’t be affected whether market rates go up or down.

That being said, there really is no “good” loan interest rate. Rather, when shopping for a loan, you need to check if the interest rate you are getting is reflective of the prevailing market rate.

Make Wise Financial Decisions with Metrobank

We have discussed how loan interest rates work and how they affect your loan. The type of interest rate applied depends on the type of loan, repayment period, and the economy. Before taking on a loan, it’s important to understand loan interest rates in the Philippines.

With Metrobank, you can enjoy fast personal loans, home loans, and car loans with low rates and manageable payment terms. Contact Metrobank today to learn more.