For borrowers, interest matters
For borrowers, interest matters
In the traditional Indian society, a ‘loan’ was considered to be a forbidden fruit. From times when ‘udhaari’ was a strict no-no, to the time when we have loans for everything, things have changed really. Now-a-days, loans are available for holidays to weddings and from homes to cars. And if this was not enough, the EMI option for any purchase keeps your credit card active!
So, while we are busy living this life on loans & credits, don’t you think you need to spend some time to understand how the interest is calculated and how much you end up paying actually? Next time you get that phone call offering you a loan, you can negotiate a good deal by reading on & learning some simple calculations.
A loan repayment has four components namely principle amount, interest rates, loan tenure and method of calculation of interest. While the first three factors are clear & elucidated, the fourth factor is what makes all the difference. Basically there are two methods of interest calculation viz flat or fixed rate and interest on reducing balance.
The fixed or flat rate method involves calculation of interest on full amount of the loan throughout the tenure of the loan. For instance, Ajay takes a loan of Rs.1 lakh for 5 years at a rate of interest of 10%. In the flat rate method, Ajay will pay principal of Rs.20,000 every year (1,00,000/5) and interest of Rs.10,000 every year (10,0000*10%). In this manner, he pays an amount of Rs.30,000 every year. If you calculate on a monthly basis, he has a payout of Rs.2500 per month. His total interest payment over the tenure of the loan is Rs.50,000. The effective interest rate by this method of calculation is actually 17.27% per annum.
Caution: Do not confuse fixed rate method of interest calculation with fixed interest rate loans.
Now think that If Ajay’s loan was on a reducing balance method, his payouts would change. In this method, the repayments that you make are used to reduce the balance of your outstanding loan amount. The interest is then calculated on this reduced balance either on annual reducing balance or a monthly reducing balance.
Remember a simple formula for interest calculation in the reducing balance method –
Interest= Interest rate per installment*Loan outstanding
So for the first year, the interest will be= 10%*1,00,000=10,000. Second year interest=10%*83621=8362 and so on. For the monthly reducing balance method, the same formula can be used for calculating the monthly interest. The monthly reducing balance method thus results in the lowest rate of interest in effect.
Flat rate method is used in microfinance. Most of the bank loans like the home or vehicle loans use the monthly reducing balance methods of calculation.
However, In case of home loans which are generally high value and long in tenure, the monthly repayment or the EMI has a higher component of interest and lower principal. That’s precisely why a home loan does not seem to reduce at all during the initial few years, in spite of you making your EMI payments regularly. With passage of time the interest component reduces and your repayment goes towards the principle.
Before signing on the dotted line of the loan agreement, understand the method of calculation of interest. Because the rate quoted might be the same but now you know that the method of calculation makes the real difference.
