Personal loan can be taken by a person for any purpose, it can be for a vacation, to meet medical bills, to renovate the house, etc. When you are applying for the loan, look carefully for the interest rate that is being offered to you. The interest rate is set based on your credit score, your age and the amount of loan that you have taken and the period you have chosen to repay it. Apart from negotiating the interest rate, you must also check the way the interest rate is being calculated. There are two methods by which the interest rate is calculated; flat interest rate and reducing balance interest rate method.
As the name implies, the interest rate is calculated on the full amount of the loan throughout its tenure. The effective interest rate is higher than the nominal flat rate that is usually quoted in the beginning. For instance, Madhuri was offered a personal loan at 10% interest and the other banks that she had inquired with were offering her interest between 14-16%. She was pleasantly surprised. She started asking around and finally met with a chartered accountant friend of hers who asked her if the interest rate was calculated on a flat or a reducing balance method. On checking with the bank she found out that the interest rate was calculated on the flat interest rate method. If she would’ve taken a loan of Rs.5 lakhs for 5 years, she would be paying Rs.2,50,000 towards interest. Her EMI would be Rs.12,500. The interest paid in the first month and interest paid on the last month will not change and it will remain the same at Rs.4,167.
Most often the banks will follow this method of calculating Interest for Personal Loans. The interest is to be paid on the entire loan amount throughout the tenure.
The interest in reducing interest rate method is calculated on the outstanding loan amount every month. The EMI includes the interest payable on the outstanding loan amount. For instance if Madhuri had taken the loan of Rs.5 lakhs for 5 years on a 16-15% diminishing interest rate, she would’ve spent Rs.2,29,542 if it was 16% diminishing interest and if the diminishing interest rate was 15%, she would’ve spent Rs.2,13,698 towards total interest. Her monthly EMI would be Rs.12,159, if the diminishing interest rate was 16%. If it was 15% diminishing interest rate it would be Rs.11,895. The interest paid in the first month if the diminishing interest rate was 16%, would be Rs.6,593 and if it was 15% diminishing interest rate, it would be Rs.6,179. The last month interest rate that is to be paid if she had 16% diminishing interest rate would be Rs.160 and if she was charged 15% diminishing interest rate it would be Rs.148.
In the flat interest rate method, the interest is calculated on the principal loan amount. The interest on the diminishing interest rate method is calculated on the outstanding loan amount. Flat interest rates are lower than that of the reducing balance rate. The interest rate calculation for flat interest rate is easier than that of reducing interest rate. But, in practical terms, the reducing or the diminishing interest rate method is better as you will not be spending more towards the interest.
Madhuri realised that she was subject to mis-selling where the sales executive is withholding half information and is not being entirely clear about the interest rate calculation. She rejected the offer and instead chose a lender that was offering her a reducing interest rate and when she used the online interest rate calculators she realised that though she will be charged a higher rate of interest, she was saving some money.
Always look for the documents and then go ahead with the deal. All that is shown in a rosy hue is not always the best thing, there is a catch. If you are unaware of the financial products, then approach a person who can help with that regard. Don’t fall prey to the sales gimmick of the sale executives. Compare the offers and make use of the free online interest rate calculators and only when all your queries are answered, go ahead with the offer.