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	EMI	Interest payment	Principal Repayment	O/S Principal at the end of the month
1	10,00,000	21,247	8,333	12,914	9,87,086
2	9,87,086	21,247	8,226	13,021	9,74,065
3	9,74,065	21,247	8,117	13,130	9,60,935
4	9,60,935	21,247	8,008	13,239	9,47,696
5	9,47,696	21,247	7,897	13,350	9,34,346
6	9,34,346	21,247	7,786	13,461	9,20,885
7	9,20,885	21,247	7,674	13,573	9,07,312
8	9,07,312	21,247	7,561	13,686	8,93,626
9	8,93,626	21,247	7,447	13,800	8,79,826
10	8,79,826	21,247	7,332	13,915	8,65,911
11	8,65,911	21,247	7,216	14,031	8,51,880
12	8,51,880	21,247	7,099	14,148	8,37,732
13	8,37,732	21,247	6,981	14,266	8,23,466
14	8,23,466	21,247	6,862	14,385	8,09,081
15	8,09,081	21,247	6,742	14,505	7,94,576
16	7,94,576	21,247	6,621	14,626	7,79,951
17	7,79,951	21,247	6,500	14,747	7,65,203
18	7,65,203	21,247	6,377	14,870	7,50,333
19	7,50,333	21,247	6,253	14,994	7,35,339
20	7,35,339	21,247	6,128	15,119	7,20,220
21	7,20,220	21,247	6,002	15,245	7,04,974
22	7,04,974	21,247	5,875	15,372	6,89,602
23	6,89,602	21,247	5,747	15,500	6,74,102
24	6,74,102	21,247	5,618	15,630	6,58,472
25	6,58,472	21,247	5,487	15,760	6,42,712
26	6,42,712	21,247	5,356	15,891	6,26,821
27	6,26,821	21,247	5,224	16,024	6,10,798
28	6,10,798	21,247	5,090	16,157	5,94,641
29	5,94,641	21,247	4,955	16,292	5,78,349
30	5,78,349	21,247	4,820	16,427	5,61,922
31	5,61,922	21,247	4,683	16,564	5,45,357
32	5,45,357	21,247	4,545	16,702	5,28,655
33	5,28,655	21,247	4,405	16,842	5,11,813
34	5,11,813	21,247	4,265	16,982	4,94,831
35	4,94,831	21,247	4,124	17,123	4,77,708
36	4,77,708	21,247	3,981	17,266	4,60,442
37	4,60,442	21,247	3,837	17,410	4,43,032
38	4,43,032	21,247	3,692	17,555	4,25,476
39	4,25,476	21,247	3,546	17,701	4,07,775
40	4,07,775	21,247	3,398	17,849	3,89,926
41	3,89,926	21,247	3,249	17,998	3,71,928
42	3,71,928	21,247	3,099	18,148	3,53,781
43	3,53,781	21,247	2,948	18,299	3,35,482
44	3,35,482	21,247	2,796	18,451	3,17,031
45	3,17,031	21,247	2,642	18,605	2,98,425
46	2,98,425	21,247	2,487	18,760	2,79,665
47	2,79,665	21,247	2,331	18,917	2,60,749
48	2,60,749	21,247	2,173	19,074	2,41,675
49	2,41,675	21,247	2,014	19,233	2,22,442
50	2,22,442	21,247	1,854	19,393	2,03,048
51	2,03,048	21,247	1,692	19,555	1,83,493
52	1,83,493	21,247	1,529	19,718	1,63,775
53	1,63,775	21,247	1,365	19,882	1,43,893
54	1,43,893	21,247	1,199	20,048	1,23,845
55	1,23,845	21,247	1,032	20,215	1,03,630
56	1,03,630	21,247	864	20,383	83,247
57	83,247	21,247	694	20,553	62,693
58	62,693	21,247	522	20,725	41,969
59	41,969	21,247	350	20,897	21,071
60	21,071	21,247	176	21,071	Nil

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
1	10,00,000	25,000	8,333	16,667	9,83,333
2	9,83,333	25,000	8,333	16,667	9,66,667
3	9,66,667	25,000	8,333	16,667	9,50,000
4	9,50,000	25,000	8,333	16,667	9,33,333
5	9,33,333	25,000	8,333	16,667	9,16,667
6	9,16,667	25,000	8,333	16,667	9,00,000
7	9,00,000	25,000	8,333	16,667	8,83,333
8	8,83,333	25,000	8,333	16,667	8,66,667
9	8,66,667	25,000	8,333	16,667	8,50,000
10	8,50,000	25,000	8,333	16,667	8,33,333
11	8,33,333	25,000	8,333	16,667	8,16,667
12	8,16,667	25,000	8,333	16,667	8,00,000
13	8,00,000	25,000	8,333	16,667	7,83,333
14	7,83,333	25,000	8,333	16,667	7,66,667
15	7,66,667	25,000	8,333	16,667	7,50,000
16	7,50,000	25,000	8,333	16,667	7,33,333
17	7,33,333	25,000	8,333	16,667	7,16,667
18	7,16,667	25,000	8,333	16,667	7,00,000
19	7,00,000	25,000	8,333	16,667	6,83,333
20	6,83,333	25,000	8,333	16,667	6,66,667
21	6,66,667	25,000	8,333	16,667	6,50,000
22	6,50,000	25,000	8,333	16,667	6,33,333
23	6,33,333	25,000	8,333	16,667	6,16,667
24	6,16,667	25,000	8,333	16,667	6,00,000
25	6,00,000	25,000	8,333	16,667	5,83,333
26	5,83,333	25,000	8,333	16,667	5,66,667
27	5,66,667	25,000	8,333	16,667	5,50,000
28	5,50,000	25,000	8,333	16,667	5,33,333
29	5,33,333	25,000	8,333	16,667	5,16,667
30	5,16,667	25,000	8,333	16,667	5,00,000
31	5,00,000	25,000	8,333	16,667	4,83,333
32	4,83,333	25,000	8,333	16,667	4,66,667
33	4,66,667	25,000	8,333	16,667	4,50,000
34	4,50,000	25,000	8,333	16,667	4,33,333
35	4,33,333	25,000	8,333	16,667	4,16,667
36	4,16,667	25,000	8,333	16,667	4,00,000
37	4,00,000	25,000	8,333	16,667	3,83,333
38	3,83,333	25,000	8,333	16,667	3,66,667
39	3,66,667	25,000	8,333	16,667	3,50,000
40	3,50,000	25,000	8,333	16,667	3,33,333
41	3,33,333	25,000	8,333	16,667	3,16,667
42	3,16,667	25,000	8,333	16,667	3,00,000
43	3,00,000	25,000	8,333	16,667	2,83,333
44	2,83,333	25,000	8,333	16,667	2,66,667
45	2,66,667	25,000	8,333	16,667	2,50,000
46	2,50,000	25,000	8,333	16,667	2,33,333
47	2,33,333	25,000	8,333	16,667	2,16,667
48	2,16,667	25,000	8,333	16,667	2,00,000
49	2,00,000	25,000	8,333	16,667	1,83,333
50	1,83,333	25,000	8,333	16,667	1,66,667
51	1,66,667	25,000	8,333	16,667	1,50,000
52	1,50,000	25,000	8,333	16,667	1,33,333
53	1,33,333	25,000	8,333	16,667	1,16,667
54	1,16,667	25,000	8,333	16,667	1,00,000
55	1,00,000	25,000	8,333	16,667	83,333
56	83,333	25,000	8,333	16,667	66,667
57	66,667	25,000	8,333	16,667	50,000
58	50,000	25,000	8,333	16,667	33,333
59	33,333	25,000	8,333	16,667	16,667
60	16,667	25,000	8,333	16,667	Nil

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.