To meet the applicants' financial needs, banks and non-banking financial companies (NBFCs) provide a variety of loans. This type of financial assistance may be in the form of a Personal Loan, business loan, home loan, or car loan.
Lenders typically give borrowers a choice between a flat rate or a reducing balance rate when it comes to interest rates. In this article, we'll discuss how banks and other financial institutions determine a loan's interest rate. It is particularly important to understand this calculation beforehand to make an informed choice that benefits you.
Essentially, if you take out a loan for a set period, you must pay back the principal as well as the interest incurred over its tenure. In such a case, it’s imperative to understand the calculations that help arrive at your Personal Loan interest rate.
For estimating interest on loans, there are two widely used methods: the flat interest rate method and the reducing balance rate method. Both these methods generate different interest amounts that need to be paid by the borrower. Therefore, it is useful to understand the basis of the two methods. Let us understand what these two rates entail-.
In the flat interest rate method, the interest rate is estimated based on the entire principal amount. Here, the interest rate and amount payable remain constant throughout the loan tenure. It overlooks the fact that the monthly EMIs gradually lower the principal amount. The initial estimate for nominal flat rate is notably lower than the effective interest rate. The formula below is used to determine the fixed rate of interest:
For example, let us assume that you take out a Personal Loan for Rs. 2,00,000 for a period of 5 years or 60 months at a flat interest rate of 10%. You must pay –
Interest payable per instalment = Rs. 2,00,000 (principal) * 10% (flat interest) * 5 (no. of years) / 60 (no. of instalments) = Rs. 1,666.66 per month. That means, after adding your principal component, the EMI would be Rs. 5,000 per month. During the entire tenure, you will pay Rs. 3,00,000.
Employing the flat rate method makes calculations simple. The flat interest rate allows for transparent loan agreements. Both the lender and the borrower have easy access to them and can monitor them with ease. The calculation is made even simpler by an EMI calculator. You only need to input a few bits of information, and the calculator will quickly and accurately provide results.
You may conveniently plan your monthly finances because the EMI doesn't change from month to month. By doing this, you can avoid the hassle of monthly EMI calculations and meticulous planning.
In general, flat interest rates employ lower interest rates than reducing balance rates.
The term "reducing" or "diminishing" interest rate refers to an interest rate that is determined monthly based on the amount of the outstanding loan balance. The EMI for this option includes both the principal repayment and the payable interest on the outstanding loan balance.
Each EMI payment lowers the amount of the loan that is still due. Only the amount of the outstanding loan is used to determine the interest for the subsequent month. The following formula is used to determine the reducing balance rate:
Consider a case where you take out a Rs. 1,00,000 loan for 5 years at a 10% p.a. reducing balance rate. The amount of your EMI will decrease with each repayment. You must pay Rs. 9,270 in interest throughout the first year. The principal amount will be Rs. 83,773 in the second year, and you will be required to pay Rs. 7570 in interest.
You will only be required to pay Rs. 1,329 in interest for the last year. The borrower will pay a total of Rs. 1.27 lakh utilizing the reducing balance method as opposed to Rs. 1.5 lakh using the flat rate technique. For convenience, you can use an online reducing interest rate calculator for prompt and accurate results.
The interest payable on Personal Loans, credit cards, overdraft facilities, property loans, property mortgage loan, and housing are often determined using the reducing balance interest method. Borrowers only pay interest on the balance of their outstanding loan amount.
The main advantage of a reducing balance interest rate is that, over time, the applicant has to pay less interest compared to loans with flat interest rates.
Flat rates' ease of calculation and lower interest rates might not be as advantageous as originally believed. Although flat rates are simple to understand, they could be misleading when it comes to repaying large loans.
Use online calculators to check the Personal Loan interest rate on both options before submitting a loan application. It's important to know whether a lender calculates interest using the Flat Interest Rate method or the Reducing Balance method whenever you're thinking about taking out a loan. Converting everything into the equivalent of the Effective Interest Rate is the best method for comparing the true cost of a loan.
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