Have you ever been in a situation where a loan that sounded so simple and affordable when you signed up has ended up costing you a LOT more than you expected? You’re not alone. This often happens because the way in which interest is communicated, particularly in the informal credit market, is rarely clear.
There are two most commonly used methods to lower the perceived interest charged, which we will explain in more detail here.
Flat Rate vs. Reducing Balance Rate: Unveiling the Difference
Essentially, this is about whether the interest charged is on the full loan amount throughout the loan term, or whether this reduces based on your repayments over time.
Flat Rate:
When you opt for a loan with a flat interest rate, the entire loan amount is considered for interest calculation throughout the loan tenure. This means that regardless of the amount you've repaid, the interest is calculated on the initial principal amount. Imagine you're taking out a loan for a much-needed investment—a new car, perhaps, or your dream home. With a flat interest rate, the calculation is simple: the interest is applied to the entire principal amount for the duration of the loan. This means your monthly payments remain constant, offering a sense of stability and predictability. However, there's a catch.
While flat interest rates provide a clear picture of your repayment schedule, they come with a hidden cost. Since the interest is calculated on the initial principal amount, you end up paying a much higher real interest rate over the loan term. So whilst simple to understand, avoid fixed interest loans.
Reducing Balance Rate:
Now, let's shift our focus to reducing balance interest rates—less intuitive, but financially smarter option. Unlike flat rates, where the interest is stagnant, reducing balance rates adapt to your repayment journey. With each EMI payment, the outstanding balance decreases, leading to a corresponding reduction in the interest amount.
This dynamic nature of interest calculation is a game-changer. As you chip away at the principal amount, the interest burden lightens, allowing you to save substantially over the loan duration. While the initial EMIs may vary, reflecting the decreasing principal balance, the overall cost of borrowing is significantly lower compared to flat interest rates.
Making Sense of the Numbers: A Comparative Analysis
To illustrate the impact of these interest rate mechanisms, let's delve into a hypothetical scenario:
You've taken a loan of Rs. 1 lakh at a 10% interest rate and tenure is 5 years.
Flat Interest Rate:
Monthly EMI: Rs. 2,500
Total Interest paid over the tenure of the loan: Rs. 50,000
Total Amount Repaid: Rs. 1,50,000
Reducing Balance Interest Rate:
Monthly EMI: Rs. 2,125
Total Interest paid over the tenure of the loan: Rs. 27,482
Total Amount Repaid: Rs. 1,27,482
The Verdict:
While opting for a flat interest rate might seem appealing due to its simplicity with a fixed EMI, it's essential to recognize the long-term financial implications. The interest burden remains high throughout the loan tenure, resulting in a higher total repayment amount.
On the contrary, a reducing balance interest rate offers significant advantages. By recalculating interest based on the decreasing outstanding balance, you not only save money but also pay off your loan more efficiently. In our example, choosing a reducing balance rate translates to a substantial saving of Rs. 22,518.
Monthly vs Annual Interest rates
Now that you have understood flat vs diminishing balance, always pay attention to the tenure the interest applies to for example, monthly or annual.
Many times, we are deceived by hearing a small number like 2% per month which can trick us into believing that we are paying a very small amount as interest. However, this is far from the truth. This kind of interest is not only very high when you think about it but also does not follow the diminishing balance method.
So, a flat 2% interest rate per month will look something like this:
You've taken a loan of Rs. 1 lakh at a 2% interest rate per month and tenure is 5 years.
Monthly EMI: Rs. 3,667
Total Interest paid over the tenure of the loan: Rs. 1,20,000
Total Amount Repaid: Rs. 2,20,000
Out of all the examples in the blog, this one is the most expensive option.
It's wise to always think about interest rates on an annual basis to grasp the true cost. For instance, while 2% per month might seem manageable, seeing it as 24% interest per year gives a clearer picture and helps avoid deception.
Conclusion:
- When taking loans, it's crucial to know the difference between flat and reducing balance interest rates. Flat rates might seem straightforward, but choosing reducing balance rates is usually smarter financially and can save you a lot of money in the long run.
- Think annual and not weekly/ monthly/ quarterly. Save yourself from deceptively expensive credit.
- It's important to note that the RBI requires lenders to provide a Key Fact Statement (KFS) for loans. This document summarizes all loan details in simple terms. Take the time to review it carefully to ensure you fully understand the terms of the loan you're taking.
Disclaimer: The figures and examples used in this blog are for illustrative purposes only.
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