It is likely that while taking a loan you will find some financial institution giving a more affordable interest rate than another. But make sure that on getting such an offer you understand the EMI amount and the mode of its calculation. Your EMI can be calculated in two methods – Fixed interest rate method and reducing balance method. Be wise enough to not choose a loan provider based only on the interest rate, instead attach utmost importance to the method of EMI and interest calculation.
Let’s understand the two methods of interest calculation – fixed/simple interest calculation method and reducing balancing method. To attain more clarity on this, the following conditions shall be used –
- Loan worth is Rs. 25,00,000
- Loan Tenure is 1 year
- Rate on interest is 12%
Fixed or Simple Interest Calculation Method:
As per this method the interest is calculated on the principal amount. In this case it is Rs.25,00,000. The method is used to calculate the interest for the entire tenure of loan. In this case it will be Rs.3,00,000. The interest arrived at will be added to the principal (which will be Rs.28,00,000). This will further be divided into 12 equal parts to arrive at your monthly EMI. In this case it will be Rs.2,33,333. The total interest to be paid, in this case is Rs.3,00,000.
Reducing Balance Method:
Considering the same value for loan amount, interest rate and loan tenure, we will calculate the EMI amount arrived at, according to the reducing balance method. The EMI, post calculation, comes to Rs.2,22,121. As per this mode of interest calculation, whatever you pay towards your monthly EMI gets reduced in that principal part. Apart from this, interest will be calculated on the rest of the amount and you shall be charged for that month. So it is understandable that the principal will not be constant in this method. It decreases gradually, on a monthly basis, and at the end of 12th month the principal stands at an amount of zero. Please note that during the initial stages of the loan, the major part goes in interest and minor part goes towards principal.
Keeping the basic data same and calculating the interest with two different methods, it can be seen that the simple/fixed interest calculation method demanded a total of Rs.1,34,537 high interest than reducing balance method. This explains why it is important to look at the interest calculation method, and not just the interest rate offered. It is true that such type of simple or fixed interest calculation method loans provide you a lower interest rate than that of reducing balance method loans. Therefore, make sure that you ask the loan provider the detailed difference in interest payment, and only then decide to avail the loan. A good choice of loan provider will not only fulfil your financial needs, but also be easy on your pocket.
Advantages of Fixed Interest Loans
- The interest amount to be paid remains constant as it is calculated based on the initial principal amount borrowed by the customer.
- The monthly installments paid towards this type of a loan does not change with time.
- Under this type of a loan, the customer is offered a lot of flexibility in terms of the loan repayment tenure in order to match their repayment capacity.
- This type of a loan usually has a low interest rate, thereby, increasing the amount of loan eligibility of the customer.
- The risk associated with this loan is considerably less. Therefore, it offers a lot of peace of mind to the borrowers.
Disadvantages of Fixed Interest Loans
- The biggest drawback of this type of a loan is that the EMI amount that needs to pay is higher compared to other schemes.
- Once opted for this loan, the customer will have to continue paying the same interest rate until refinancing is done.
- The loan repayment tenure for this scheme is usually longer than other loans.
Difference between Fixed Interest Loan and Reducing Balance Loan
It is understandable for a customer to get confused while choosing the type of loan that will best suit his or her needs while paying the least amount possible as interest. Look at the list mentioned below and learn how Reducing Balance Loans differ from Fixed Interest Loans in order to determine which is the best one for you:
- The interest rate offered for Fixed Interest Loans are generally lower than that of the Reducing Balance Loans.
- While calculating the amount of interest payable for a Fixed Interest Loan is quite simple, the calculation of the interest for a Reducing Balance Loan is slightly more complex.
- The interest charged for a Fixed Interest Loan is calculated based on the initial principal amount of loan borrowed by the customer and does not change throughout the loan tenure. On the other hand, the amount of interest for a Reducing Balance Loan is deduced based on the outstanding principal amount after regular repayments periods.
- Since the interest paid for the Reducing Balance Loan reduces over time, the amount of interest paid for this type of loan is generally less than that for a Fixed Interest Loan.
- Due to a lower interest amount that needs to be paid by the borrower, the Reducing Balance Loan is better than the Fixed Interest Loan in a real time scenario.
- The loan tenure of a Fixed Interest Loan is usually longer than that of the Reducing Balance Loan.