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
|EMI||Interest payment||Principal Repayment||O/S Principal at the end of the month|
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 month||EMI||Interest payment||Principal Repayment||O/S Principal at the end of the month|
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.
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.