Beware If You Are Offered Loan at Too Attractive an Interest Rate

Those, who have been on the wrong side of loan agreements, would easily understand a small clause or even a word can create a lot of difference. When I say wrong side of the loan agreements, I mean the exact terms and conditions of the loan were different from what you thought when you took the loan.



One such clause pertains to how interest is charged. It can be charged on a flat interest rate method or a reducing balance (diminishing) method. Even at the same interest rate, principal amount and loan tenor, the EMI burden under the two methods can be vastly different.

In this post, I will discuss the difference between the two methods and how the choice of method can impact your EMI.

Flat Interest Rate

It is best explained with the help of an example.

You approach a bank to request for personal loan. The bank offered you a loan of Rs 10 lacs to be repaid in 5 years at a flat interest rate of 10% p.a. You are pleasantly surprised. Interest rate on your home loan is 10.25% p.a.  You rechecked the interest rate with the bank official and asked why the rate was lower than the home loan interest rate.

You were politely told that this was a promotional offer and was exclusively for esteemed customers such as you. Your heart swelled up with pride and you immediately signed up for the loan.

Mission accomplished for the bank official. What about you? At least so it seems, since you have been able to get the loan at such an attractive rate.

Your EMI came out to Rs 25,000. It appears on the higher side but you didn’t care as this was the best deal you could have got.

After a few months, you were discussing your finances with your investment adviser. This loan came up for discussion. As soon as your adviser heard about the EMI, he realised you have been fooled. He told you were paying an interest rate much higher than 10% p.a.

You thought he was an idiot.

He opened a spreadsheet to explain it to you.

Principal Amount (A)10,00,000
Loan Tenor (B)5
No. of Instalments (C)60
Interest Rate (D)10.0%
Total interest to be paid (E) = (A)*(B)*(D)5,00,000
Total Interest + Principal (F) = (A)+(E)15,00,000
EMI (G) = (F)/(C)25,000
Interest paid per EMI (H) = (E)/(C)8,333

Under this method, interest payment per instalment = (Original Principal Amount * Loan Tenor (in years) * Interest rate per annum)/No. of instalments

Look at how the EMI figure is arrived. Interest has been calculated upfront on the principal amount for the entire tenor of 5 years. Subsequently, interest and principal amounts are added to arrive at total payment of Rs 15 lacs. To arrive at EMI, payment of Rs 15 lacs was spread equally over 5 years. Thus monthly outgo for the month comes out to Rs 25,000 (Rs 15 lacs /60 months).

You weren’t bothered. What was wrong with that? Isn’t that how EMIs are calculated?

The answer was No.

Your investment adviser told you EMIs for home loan are not calculated in this manner. They are calculated on reducing balance or diminishing interest rate method. You were already scratching your head.

Your adviser opened a new spreadsheet to explain it to you.

Reducing Balance or Diminishing Balance Interest Rate

Under this method, a part of EMI goes towards principal repayment every month. Since the outstanding principal goes down every month, your interest liability keeps going down and a greater portion of EMI goes towards principal repayment.

Let’s try to understand this with help of an illustration.

Loan Amount = Rs 10 lacs, Tenor = 5 years and Interest Rate =10% p.a. The loan parameters have been kept same to facilitate comparison.

EMI came out to Rs 21,247, much lower than Rs 25,000 per month in case of flat interest rate.

Hence, over a period of 5 years, you will pay Rs 2.25 lacs more in case of flat interest rate.

But, How Did This Happen?

The answer is simple. Under the reducing balance method, you are repaying principal every month.

Hence, your total interest liability over the tenor of the loan is much lower.

Under flat rate method, you were paying interest for the initial principal amount for the entire tenor. On the other hand, under reducing balance, you are paying interest on reducing outstanding principal amount.

O/S Principal at the beginning of the month

EMIInterest paymentPrincipal RepaymentO/S Principal at the end of the month
110,00,00021,2478,33312,9149,87,086
29,87,08621,2478,22613,0219,74,065
39,74,06521,2478,11713,1309,60,935
49,60,93521,2478,00813,2399,47,696
59,47,69621,2477,89713,3509,34,346
69,34,34621,2477,78613,4619,20,885
79,20,88521,2477,67413,5739,07,312
89,07,31221,2477,56113,6868,93,626
98,93,62621,2477,44713,8008,79,826
108,79,82621,2477,33213,9158,65,911
118,65,91121,2477,21614,0318,51,880
128,51,88021,2477,09914,1488,37,732
138,37,73221,2476,98114,2668,23,466
148,23,46621,2476,86214,3858,09,081
158,09,08121,2476,74214,5057,94,576
167,94,57621,2476,62114,6267,79,951
177,79,95121,2476,50014,7477,65,203
187,65,20321,2476,37714,8707,50,333
197,50,33321,2476,25314,9947,35,339
207,35,33921,2476,12815,1197,20,220
217,20,22021,2476,00215,2457,04,974
227,04,97421,2475,87515,3726,89,602
236,89,60221,2475,74715,5006,74,102
246,74,10221,2475,61815,6306,58,472
256,58,47221,2475,48715,7606,42,712
266,42,71221,2475,35615,8916,26,821
276,26,82121,2475,22416,0246,10,798
286,10,79821,2475,09016,1575,94,641
295,94,64121,2474,95516,2925,78,349
305,78,34921,2474,82016,4275,61,922
315,61,92221,2474,68316,5645,45,357
325,45,35721,2474,54516,7025,28,655
335,28,65521,2474,40516,8425,11,813
345,11,81321,2474,26516,9824,94,831
354,94,83121,2474,12417,1234,77,708
364,77,70821,2473,98117,2664,60,442
374,60,44221,2473,83717,4104,43,032
384,43,03221,2473,69217,5554,25,476
394,25,47621,2473,54617,7014,07,775
404,07,77521,2473,39817,8493,89,926
413,89,92621,2473,24917,9983,71,928
423,71,92821,2473,09918,1483,53,781
433,53,78121,2472,94818,2993,35,482
443,35,48221,2472,79618,4513,17,031
453,17,03121,2472,64218,6052,98,425
462,98,42521,2472,48718,7602,79,665
472,79,66521,2472,33118,9172,60,749
482,60,74921,2472,17319,0742,41,675
492,41,67521,2472,01419,2332,22,442
502,22,44221,2471,85419,3932,03,048
512,03,04821,2471,69219,5551,83,493
521,83,49321,2471,52919,7181,63,775
531,63,77521,2471,36519,8821,43,893
541,43,89321,2471,19920,0481,23,845
551,23,84521,2471,03220,2151,03,630
561,03,63021,24786420,38383,247
5783,24721,24769420,55362,693
5862,69321,24752220,72541,969
5941,96921,24735020,89721,071
6021,07121,24717621,071Nil

You can see interest portion on the EMI keeps reducing while the principal repayment portion keeps increasing. Since interest is calculated on the principal outstanding at the beginning of the month, interest portion keeps going down. When you are towards the end of the loan tenor, bulk of your EMI goes towards principal repayment.

Let’s do the same exercise for flat interest rate loan.

O/S Principal at the beginning of the monthEMIInterest paymentPrincipal RepaymentO/S Principal at the end of the month
110,00,00025,0008,33316,6679,83,333
29,83,33325,0008,33316,6679,66,667
39,66,66725,0008,33316,6679,50,000
49,50,00025,0008,33316,6679,33,333
59,33,33325,0008,33316,6679,16,667
69,16,66725,0008,33316,6679,00,000
79,00,00025,0008,33316,6678,83,333
88,83,33325,0008,33316,6678,66,667
98,66,66725,0008,33316,6678,50,000
108,50,00025,0008,33316,6678,33,333
118,33,33325,0008,33316,6678,16,667
128,16,66725,0008,33316,6678,00,000
138,00,00025,0008,33316,6677,83,333
147,83,33325,0008,33316,6677,66,667
157,66,66725,0008,33316,6677,50,000
167,50,00025,0008,33316,6677,33,333
177,33,33325,0008,33316,6677,16,667
187,16,66725,0008,33316,6677,00,000
197,00,00025,0008,33316,6676,83,333
206,83,33325,0008,33316,6676,66,667
216,66,66725,0008,33316,6676,50,000
226,50,00025,0008,33316,6676,33,333
236,33,33325,0008,33316,6676,16,667
246,16,66725,0008,33316,6676,00,000
256,00,00025,0008,33316,6675,83,333
265,83,33325,0008,33316,6675,66,667
275,66,66725,0008,33316,6675,50,000
285,50,00025,0008,33316,6675,33,333
295,33,33325,0008,33316,6675,16,667
305,16,66725,0008,33316,6675,00,000
315,00,00025,0008,33316,6674,83,333
324,83,33325,0008,33316,6674,66,667
334,66,66725,0008,33316,6674,50,000
344,50,00025,0008,33316,6674,33,333
354,33,33325,0008,33316,6674,16,667
364,16,66725,0008,33316,6674,00,000
374,00,00025,0008,33316,6673,83,333
383,83,33325,0008,33316,6673,66,667
393,66,66725,0008,33316,6673,50,000
403,50,00025,0008,33316,6673,33,333
413,33,33325,0008,33316,6673,16,667
423,16,66725,0008,33316,6673,00,000
433,00,00025,0008,33316,6672,83,333
442,83,33325,0008,33316,6672,66,667
452,66,66725,0008,33316,6672,50,000
462,50,00025,0008,33316,6672,33,333
472,33,33325,0008,33316,6672,16,667
482,16,66725,0008,33316,6672,00,000
492,00,00025,0008,33316,6671,83,333
501,83,33325,0008,33316,6671,66,667
511,66,66725,0008,33316,6671,50,000
521,50,00025,0008,33316,6671,33,333
531,33,33325,0008,33316,6671,16,667
541,16,66725,0008,33316,6671,00,000
551,00,00025,0008,33316,66783,333
5683,33325,0008,33316,66766,667
5766,66725,0008,33316,66750,000
5850,00025,0008,33316,66733,333
5933,33325,0008,33316,66716,667
6016,66725,0008,33316,667Nil

Under the flat rate interest rate method, you can see monthly interest payment and principal repayment have been decided upfront. The amounts are independent of the outstanding principal at the end of the month.

What Is the Effective Cost of Loan under the Flat Rate?

You can use IRR function to calculate effective cost. The cost comes out to 17.27% per annum. This means, for these loan terms, 10% p.a. under flat rate is equal to 17.27% under reducing balance method.

So, if another bank had even offered you an interest rate of 15% p.a. under reducing balance method, you would have been far better off taking loan of 15% p.a. EMI at 15% p.a. would have been Rs 22,244.

Conclusion

Flat interest rate loans will be offered at very low rates. Sometimes, when a loan is being offered at too attractive a rate, it should set alarm bells ringing. You should read the terms and conditions even more carefully. Banks cannot offer loans below their base rates. If you can’t do that on your own, request a friend to do it for you or seek professional help.

Banks use such tricks to attract customers. You can say that the bank officials did not act in an ethical manner by not explaining you the product properly. Well, you cannot control how bank officials behave. They have targets and are under immense pressure. However, as a party to the agreement, it is your responsibility too to understand the terms and conditions of the loan properly.



2 responses to “Beware If You Are Offered Loan at Too Attractive an Interest Rate

  1. Thank you very much for the detailed explanation. But I don’t see any banks offering flat rate personal loans except for Capital Bank. General public is well aware of the difference now .

  2. I dont think the banks are trying to fool anyone if they stated 10% Flat up front. It does seem a more attractive rate and I’ve seen this being used for many short-term loans. Apart from the two you mentioned, banks could offer daily/weekly/monthly reducing and the onus is on the borrower to understand what it means. As they say, ignorance is not an excuse.

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