Sandeep Nanduri, the top local official in Tirunelveli district, said the labourer had taken a loan of Rs 1.42 lakh earlier this year to start a business but was being pressured to pay more interest.
The labourer, identified only as Esakimuthu, had repaid nearly double the loan but the lender was pushing for around Rs 2 lakh more in repayments.
Mr Nanduri said Esakimuthu was allegedly pressured by police to repay the extra interest, driving him to desperation.
"We have started an investigation over allegations that the police and officials didn't help the man," Mr Nanduri told AFP.
"A police officer has been transferred and his role is being investigated."
The lender has been arrested on charges of assisting suicide and breaching laws on charging exorbitant interest, Mr Nanduri said.
Most states have criminalised commercial moneylending. All lenders, both formal and informal, are banned from charging interest rates above 21 percent on loans.
Thousands of people with low-income, mostly farmers, are often denied loans by banks and rely on unscrupulous lenders for quick cash.
Private lenders charge steep interest rates upwards of 50 percent, locking borrowers in a cycle of debt. Many use threats and force to reclaim unpaid loans.
Hundreds of farmers crippled by debt have committed suicide in recent years, especially in Tamil Nadu where a bad drought put enormous financial pressure on poor families.
Nearly 48 percent of farmers in the country took loans from informal sources such as moneylenders and landlords, according to a 2012 report by All India Debt and Investment Survey.