Banks and financial institutions offer personal loans to help people deal with financial emergencies or fulfil their long awaited desires. A personal loan can be taken without pledging an asset as security and hence it is one of the most demanded financial products. While all banks may offer competitive personal loan interest rates based on the borrower's credit profile, the method of interest calculation is also an important thing to consider. The lenders may paint a dreamy picture of lower rates and other benefits but as a smart buyer you must know how the interest is charged by banks and financial institutions.
Interest rates on personal loan may be calculated by two methods- reducing balance method or flat rate method. This should not be confused with fixed and floating rates of interest. Fixed rate of interest is the rate that does not fluctuate with the changes in market conditions. Here we are concerned with the method of interest calculation.
Let us discuss these two methods of interest calculation in some detail.
Flat Rate Method of Interest Calculation
Flat rate method can also be referred to as the straight line method and is calculated on the principal amount of the loan throughout the loan tenure. When you pay EMIs every month, it reduces the amount of principal borrowed but in case of flat interest rate the principal amount on which the interest is calculated remains the same as what was borrowed by you in the beginning. A number of banks, nowadays, refrain from charging interest through this method as the public is now aware that this is not really a good deal. Although the principal amount keeps reducing, you keep paying the same high interest rate.
Let us understand this with the help of an example.
Suppose you take out a personal loan for Rs 3,50,000 at the rate of 12% p.a. (flat rate) for a tenure of 3 years. In this case, your yearly interest pay-out will be Rs 42,000 and per month you will have to pay Rs 3,500 towards interest. In three years, the total interest you pay will be equal to Rs 1,26,000. Flat interest rates can be 1-2% higher when converted into effective rates.
Reducing Balance Method of Interest Calculation
Most of the banks calculate interest rate on reducing balance method. Under this method, the interest is calculated on the outstanding loan amount that is the amount remaining after previous interest deduction. So every time, the interest amount that you have to pay also reduces. This method of calculation is beneficial for the borrower as the total interest cost significantly reduces.
Let us find out how calculation of personal loan EMI on reducing balance method for the same amount as in the previous method differs.
Principal = Rs 3,50,000
Rate = 12% p.a.
Tenure = 3 years
The EMI for the first month would be Rs 11,625 out of which principal repayment is Rs 8,125 and interest component is Rs 3,500.
However, this amount will not remain same for all interest calculations. The remaining principal is now Rs (3,50,000 – 8,125) = Rs 3,41,875. The next interest will be calculated on this amount and not on the initially borrowed principal. So, the next EMI will be Rs 3418.75. All the next EMIs will be calculated on the outstanding loan amount.
In the above table, you can see how the interest pay-out has reduced with each year in the reducing balance method. The overall interest cost in this method will be Rs 68,500 which is much lesser as compared to the flat rate method in which you would have to pay Rs 1,26,000 as interest. The difference is as high as Rs 57,500.
If you use a personal loan EMI calculator, it is highly probable that the result will be based on reducing balance method as the flat rate method is quite uncommon, nowadays.
Difference between the Flat Rate Method and Reducing Balance Method
Both the methods of interest calculation on personal loan are logical. However, the flat rate method is less beneficial for the borrowers as they end up paying a higher amount as interest since the principal amount for interest calculation remains unchanged. Alternatively, under reducing balance method, the interest amount reduces as you pay off the EMIs. The table given below describes the main differences between reducing balance method and flat rate method-
The Bottom Line
As discussed above, the reducing balance method of calculating interest has more practical value as the total interest pay-out is technically lower. It is easy to get enticed into a personal loan offer at surprisingly low rate but, as a smart borrower, you must ask the lender about how the interest would be calculated. You will be shocked to see that a 10 percent interest rate calculated on flat rate method would cost higher than a 15 percent interest rate loan when calculated on reducing balance method.
Most of the banks calculate personal loan interest on the basis of reducing balance method. However, there may be a few Non-Banking Financial Corporations (NBFCs) trying to entice customers with a lower rate of interest since they will make better profits by using the flat rate method. Hence, it is in the interest of the borrowers to be sure about the method of interest calculation that the lender is using. Do not get lured into a lower interest rate. Raise questions, be informed and then take the step.