To help people achieve their financial desires, various financial firms and banks come forward and offer loans. You can get a vehicle loan, education loan, home loan, personal loan, gold loan, and property loan from banks. Most of the banks offer such loans at reasonable interest rates. It’s obvious that the bank agents will only display the golden side of their system. They won’t be willing to go into detail about the terms and conditions. It is you who needs to find out what lies behind the glittery and golden side. So, it’s important for a person to have a good insight before availing of their services.
Whenever you’re taking a loan, you’re supposed to repay the whole amount along with interest. That’s the general rule very bank follows. However, the method of calculating interest may vary. Except for the interest bank charges, you also need to enlighten yourself about the methods used for calculating the interest.
In this guide, we’ll throw light on how banks calculate the rate of interest on loans. We’ve differentiated between Flat interest rates and Reducing interest rates so that you don’t get a blurry picture. Read on to get a detailed analysis of their system of calculation with different examples.
Flat Interest Rates
Here, in this method, the rate of interest is determined considering the full amount that’s lent to a customer, excluding the monthly EMIs. Hence, the Effective Interest Rate succeeds in the Flat Rate, which was assured at the beginning.
Flat Interest Rate method is applied while calculating the rate of interest for vehicle loans and personal loans. If your interest is being calculated using this method, then you need to pay the entire loan throughout the tenure. Even if the loan is eventually paid down, the interest is not going to reduce with time. Usually, the Flat Interest Rates ranges from 1.7 to 1.9 times higher when converted to the Effective Interest Rate equivalent.
Let us take an example to understand the concept more clearly. You borrow Rs 1 lakh loan on the interest of 10% for 3 years. Hence, every year you’ve to pay 10,000 as interest. When you put together the rate of interest and the principal amount, the total would be Rs 1,30,000 (Rs 1,00,000 + Rs 30,000). The amount will be further divided for 3 years, i.e., Rs 1,30,000/36 months, which turns out to be Rs 3612 for a year.
Reducing Interest Rate
Meanwhile, in this method, the interest rate is calculated over the outstanding loan every month. Here, the EMI includes principal repayment plus the interest that’s supposed to be paid for the outstanding loan. With each payment of EMI, there’s a reduction in the unpaid amount. Hence, interest for the month after that is calculated on the remaining amount only.
This method is applicable, particularly on property loans, housing, overdraft facilities, mortgage, & credit cards. Here, you only have to pay the interest on the unpaid amount instead of the principal amount. Unlike the flat interest rate, you save yourself a good deal of money here.
For example, you borrowed Rs 1 lakhs at an interest of 10% for five years. Here your EMI is going to decrease with every payment. How? Let’s see. For the 1st year, you’d have to pay an interest of Rs 10,000. However, in the 2nd year, the rate of interest reduces to Rs 8,000. Following this method, when it comes to the last year, you’d only have to pay an interest of Rs 2,000. If you would’ve calculated it using the flat interest rate, you would’ve to pay Rs 1.5 lakhs. However, in this case, instead of 1.5 lakhs, you only need to pay Rs 1.3 lakhs. Doesn’t it save you money? It seems so!
Major differences between Flat Rate and Reducing Rate
- Reducing Interest rate has a shorter tenure than the Reducing interest rate
- In the case of a flat interest rate, the EMI doesn’t increase or decrease over time. However, when it comes to reducing the interest rate, the rate of interest changes based on the unpaid amount.
- If you see from the borrower’s eyes, reducing the interest rate is better than the flat interest rate because of the lower amount of interest that the borrower pays.
- Reducing the interest rate is more complex to calculate than the flat interest rate.
If you ask the customers, they find the flat rate interest misleading and a trap to attract customers. Also, we’re not asking you to blindly believe what we say. All we’re asking you is to do proper research work before you take a loan. This is because your financial status in the future depends upon it. Go for whatever seems reasonable to you. However, the best way to compare is by converting them to the Effective Interest Rate.