The process of applying for loan calls for studying its different aspects. If not investigated properly, you may land yourself into a big trouble. In this article, we are talking about how banks and other financial institutions calculate the interest rate on a loan and thus it is necessary to understand before applying for any loan. In simple terms, when you take a loan for a particular period, you’re required to repay the principal amount along with the interest within that period. Apart from the rate of interest on loan, it is very much important to know how the bank will calculate interest on your loan. As of now, there are two common methods that are used for calculating interest on loans – Flat interest rate method and reducing balance interest rate method. Let’s check out what are these methods and how do they differ from each other.
Flat Interest Rate
Flat interest rate, as the term implies, means an interest rate that is calculated on the full amount of the loan throughout its tenure without considering that monthly EMIs gradually reduce the principal amount. As a result, the Effective Interest Rate is noticeably higher than the nominal Flat Rate quoted in the beginning. The formula of calculating fixed rate of interest is -
Interest Payable per Instalment = (Original Loan Amount * No. of Years * Interest Rate p.a.) / Number of Instalments
For example, if you take a loan of Rs 1, 00,000 with a flat rate of interest of 10% p.a. for 5 years, then you would pay:
Rs 20,000 (principal repayment @ 1, 00,000 / 5) + Rs 10,000 (interest @10% of 1, 00,000) = Rs 30,000 every year or Rs 2,500 per month.
Over the entire period, you would actually be paying Rs. 1, 50,000 (2,500 * 12* 5). Therefore, in this example, the monthly EMI of Rs. 2,500 converts to an Effective Interest Rate of 17.27% p.a.
This method is particularly used to calculate the interest payable for personal loans and vehicle loans. In this method, you have to pay interest on the entire loan amount throughout the loan tenure. It is actually less popular among the borrowers because even if you gradually pay down the loan, the interest does not decrease. Flat interest rates generally range from 1.7 to 1.9 times more when converted into the Effective Interest Rate equivalent.
Reducing / Diminishing Interest Rate
Reducing/ Diminishing balance rate, as the term suggests, means an interest rate that is calculated every month on the outstanding loan amount. In this method, the EMI includes interest payable for the outstanding loan amount for the month in addition to the principal repayment. After every EMI payment, the outstanding loan amount gets reduced. Therefore, the interest for the next month is calculated only on the outstanding loan amount. The formula for calculating reducing balance interest is -
Interest Payable per Installment = Interest Rate per Installment * Remaining Loan Amount
For example, if you take a loan of Rs 1, 00,000 with a reducing rate of interest of 10% p.a. for 5 years, then your EMI amount would reduce with every repayment. In the first year, you would pay Rs 10, 000 as interest; in the second year you would pay Rs. 8,000 on a reduced principal of Rs. 80,000 and so on, till the last year, you would pay only Rs. 2,000 as interest. Unlike the fixed rate method, you would end up paying Rs. 1.3 lakh instead of Rs. 1.5 lakh.
This method is particularly used to calculate the interest payable for housing, mortgage, property loans, overdraft facilities, and credit cards. In this method, you have to only pay interest on the outstanding loan amount. The interest rates quoted for such loans are the Effective Interest Rate, which is similar to the interest rates used for Fixed Deposits (FD) and Savings Accounts.
Difference between Flat Interest Rate and Reducing Balance Rate
- In flat rate method, the interest rate is calculated on the principal amount of the loan. On the other hand, the interest rate is calculated only on the outstanding loan amount on monthly basis in the reducing balance rate method.
- Flat interest rates are generally lower than the reducing balance rate.
- Calculating flat interest rate is easier as compared to reducing balance rate in which the calculations are quite tricky.
- In practical terms, the reducing rate method is better than the flat rate method.
Whenever you consider taking a loan, it is important to know if the lender is using the Reducing Balance Method or Flat Interest Rate method to calculate interest. The best approach to compare the true cost of loan is to convert everything into the Effective Interest Rate equivalent. All the best for your loan application endeavour!
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