# 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?

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.

## 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.