Home » News » Personal Finance»Home Loan
Mar 20, 2013, 12.47 PM | Source: Moneycontrol.com

Understanding how your home loan offer works

To understand how a home loan works one needs to understand what a rest means. A rest is the interval at which the remainder of the loan amount is recalculated as you repay the loan.

BankBazaar.com

To understand how a home loan works one needs to understand what a rest means. A rest is the interval at which the remainder of the loan amount is recalculated as you repay the loan.

Financial institutions have various parameters surrounding the loan amount detailing the manner in which the loan is repaid. A “Rest” is nothing but the regular interval at which the loan amount balance is recalculated and also refers to the periodicity of compounding. This can be possible only in the case of reducing balance loan amounts.

These regular intervals or Rests can be yearly, monthly or even daily.

How to choose your home loan offer
For the twins Gayathri and Sanjana, fate intended that everything in their lives should happen in unison. Be it their first visit from the tooth fairy or their first job, the precision in timing was astounding. It so happened that they decided to buy their dream homes too around the same time.

The destiny that bound them together did not apparently bind their natures as Gayathri was very laid back and did not care too much for numbers, so she approached the first friendly bank who treated her like a queen, when she applied for a loan and took their best offer. Sanjana on the other hand did her research and had offers from several banks. Back at home Sanjana compared notes with Gayathri, who almost jumped for joy. She felt that she had landed an excellent loan bargain with minimum fuss, unlike her sister. After all, for the same loan amount of Rs. 20 L with a 20 yr loan tenure, Gayathri had an annualized interest rate of 12.75%, while the two loans that Sanjana had shortlisted from a bunch of loan offers, were both quoted at an annualized interest rate of 13% ! However, Gayathri’s joy was short lived, when Sanjana explained how appearances can prove to be deceptive!

The loan offer Gayathri obtained was a flat rate loan. Banks can calculate their interest rates either at a flat rate or a reducing balance rate. Sanjana on the other hand, had shortlisted two reducing balance loan offers with different rest periods. As her calculations revealed the loan offer with a monthly rest turned out to be a better loan bargain than the one with an annual rest. Let us examine these two aspects stated above in detail.

At a flat rate , the interest rates are calculated keeping the outstanding amount (i.e. the amount on which interest is calculated) constant throughout the loan tenure while in a reducing balance loan the interest rate is recalculated on a periodic basis based on the reducing outstanding loan amount.

Sanjana explained to Gayathri that at any given point in time, an X% flat rate is always more expensive than an X% annual reducing balance rate. Even in the case of a reducing balance loan a significant factor that impacts the loan cost is the time interval at which the reducing balance is recalculated, which could be monthly, daily, yearly, quarterly or half yearly. These time periods are known as rests, which denotes the regular interval at which the loan amount balance is recalculated and also refers to the periodicity of compounding. This can be possible only in the case of reducing balance loans.

The table below has the results of Sanjana’s calculations that helped Gayathri calculate the real cost of her loan.

Loan type  A B
Gayathri’s Flat Rate Loan Sanjana’s Reducing Balance Loan
Annualized interest rate for a Rs.20 L loan with a loan tenure of 20 yrs 12.75% 13.00%
Type of Rest Does not apply Annual Rest Monthly Rest
EMI  Rs. 29,583 Rs.23,726 Rs.23,432
Total interest paid 51 L 36.94 L 36.23 L

 

 

Flat rate loan vs. Reducing balance loan
In the above table, a comparison between Column A and B reveals the difference in the impact between a flat rate loan and a reducing balance loan.
It is clear that the effective interest that Gayathri will need to pay up with her current loan offer is much higher amounting to 51 L while the loan offers Sanjana had zeroed in on for the same loan amount and tenure was much lower showing a difference of nearly Rs. 20 L in the interest paid out!

Choosing the offer with the ideal ‘rest’
To make the most of your reducing balance loan you need to ensure the periodicity of repayment closely matches the frequency of your rest.

Sanjana was quick to realize this and her calculations revealed that a yearly rest or an annual rest would mean that even when you pay EMIs on a monthly basis on your loan, the loan amount based on which you pay the interest, will be recalculated only at the end of the year (12 months). This means you would continue to pay interest on the entire loan amount till that particular year (compounding period, when the outstanding loan amount is recalculated) ends, even when the outstanding loan amount reduces each month.

In the case of a monthly rest, the balance loan amount is recalculated and decreases every month. Hence it is to the advantage of Sanjana to take up a loan offer with the rest that more closely matches the frequency of her loan repayment. So if you are repaying your loan amount on a monthly basis, take up the loan offer that gives you the best rate on a monthly rest.

Banks generally quote an “annualized” interest rate, but remember that interest rates can be deceptive unless you figure out how they are defined. You can easily calculate the total amount of interest that you will pay for each offer by multiplying your EMI into the number of monthly installments and subtracting the loan amount from this figure. You can then easily identify which loan is the most cost effective for you. Remember to account for any upfront fees (e.g. processing fee) while comparing two loans.

What about daily reducing balance, you may wonder! Well, it makes sense to opt for a daily reducing balance only if you receive your income at different points of time during a month and can repay your loan at several or different points of time during a month. While this may not make sense for a salaried individual unless he or she has several sources of passive income, it becomes very relevant to self-employed people or individuals in a business that will have incoming funds at irregular intervals. For e.g. LIC has plans to launch a specific loan scheme for self-employed individuals where they can opt to pay daily or even quarterly payments.

In summary, the key to understanding your loan offers from multiple banks is to calculate the total amount of interest and fees you would pay for each offer and zero in on the offer that gives you the least total interest outflow.



 

BankBazaar.com is an online marketplace where you can instantly get the lowest loan rates , compare and apply online for your personal loan , home loan , car loan and credit card from India's leading banks and NBFCs.

ADS BY GOOGLE

Ask the Experts

Get your Personal Finance queries answered

  • Q

    Interest rates are going to go down. And all my fixed deposits will be maturing next year. I will have to renew my fixed deposits next year at lower rate of interest. What is the way out?

    A

    Interest rates keep fluctuating due to various micro- and macro- economic factors. There is never an ideal rate of interest. In a high inter...

  • Q

    If I put Rs 2 lakh in PPF, how much tax rebate I will get?

    A

    As per the existing guidelines and rules a person cannot deposit more than 1.5 lacs in one PPF account. However you can deposit money in the...

  • Q

    I want to buy online term life insuance plan. Which is the best one? Should I go for single premium or regular premium policy?

    A

    Single premium term insurance policies don?t make much sense. Why pay such a large amount at one go when you have the option of paying in sm...

  • Q

    I want to invest some money with at least ten years view. I dont want share market risk. Can I invest in NSC? Is there any other investment option?

    A

    NSC or National Savings Certificate is a safe investment scheme offered by the Central Government. It is an ideal option for investors with ...

  • Q

    Is it a good idea to invest in asset allocation funds? if yes, please suggest some good fund to invest money. I am 35 years old and can invest Rs 10000 per month.

    A

    Asset Allocation Funds are for those investors who want to take an exposure into different asset classes but do not wish to create their own...

  • Q

    My CA says that I have to pay tax on interest accrued on my FD of Rs 20 lakh. I have submitted form 15H in all banks. Is it necessary to pay tax in this case?

    A

    In case of interest on fixed deposits which is taxable under the head ?Income from other Sources? a taxpayer has two choices. Either you can...

  • Q

    Please suggest a good investment option of land in South India. I want to buy a land parcel of around 2 acres.

    A

    If you take a look at the South Indian real estate market, Bangalore has emerged as a clear winner. Due to the strong presence of IT/ITeS an...

  • Q

    I want to invest Rs 20000 per month. I have identified Reliance Small Cap Fund and DSPBR Micro cap fund for investment. I can hold to investments for two years. Is it a good idea to invest in these schemes? How much returns I will be getting?

    A

    If you are an aggressive investor, you can consider investing in either of the 2 funds.DSPBR Micro Cap My suggestion is that if you are inve...

  • Q

    I want to save my money for retirment Please suggest a good insurance policy

    A

    For retirement it is advisable to use multiple investment instruments and not just life insurance policies. If you have 15 years or so for r...

  • Q

    IS IT a Good time to invest in GOLD ?

    A

    Currently the outlook for gold is bearish/negative. However if you are planning for a long-term investment in gold it is ideal to invest the...

  • Q

    I have retired from my job in November. I have got Rs 48 lakh from my employers, by way of epf, gratuity and other benefits. Should i invest in senior citizen scheme of LIC? How about pension plans from LIC?

    A

    1. You can invest Post office Senior Citizen Scheme. 2. You also should invest lumpsome in MIP in post office and get monthly interest. 3. K...

  • Q

    I want to save Rs 1 crore for my retirement when i turn 60. Now I am 42 years old and have fixed deposits worth Rs 18 lakh.What should I do to reach Rs 1 cr mark?

    A

    start investing a minimum 5000 per month in mutual fund and increase 10% to 20% every year....

  • Q

    I want to save on my utility bills and fuel expenses.Please suggest a good credit card for me.

    A

    Yes, you will be able to save on Utility bills and fuel expenses through the cash back schemes offered by some of the credit card companies....

  • Q

    Suggest couple of equity mutual funds for me. I am keen to invest Rs 25000 per month for next couple of years. I can remain invested for at least five years?

    A

    Asset Allocation Funds are for those investors who want to take an exposure into different asset classes but do not wish to create their own...

  • Q

    I am a senior citizen.I received interest of Rs .1,70,000/- on FD.I have duly filled 15G form.I have NO other source of income.Have I to pay Income tax on this interest or can it be excempted?

    A

    Sir, please note if you are less than 80 years but more than 60 years of age, your total income upto Rs 3,00,000 is exempt from tax, you are...

  • Q

    Please suggest a good money back policy for me. I am 27 years old and want to accumulate Rs 10lakh over 10 years.

    A

    If you are a fan of traditional money back policies, go in for the LIC New Money Back Policy of 20 or 25 years. I would suggest you go in fo...

  • Q

    I want to buy a life insurance for my brother Please suggest a good policy. He is 19 years old. he should get Rs 5 lakh when he turns 25 years.

    A

    Best to go in for a ULIP in case he is looking to grow the money also. Go in for a ULIP like HDFC Click 2 Invest which is very low on charge...

  • Q

    In 2013, I bought an Endowment policy from LIC. Premium for that is around 35K per year. Now i understand, this was a big mistake and i want to go for a term insurance policy. I have already paid two premiums in 2013 and 2014 and I want to make this policy paid-up. Can i pay one more premium this year and make that endowment policy paid-up ? Or is there any better alternative ? Please suggest.

    A

    Yes, you can convert to a paid-up policy after 3 years premiums have been paid. I would recommend that you surrender the plan and take back ...

  • Q

    Is zero depreciation cover a good option under auto insurance? I have plans to buy honda city in January

    A

    Zero depreciation is a good option to along with the standard car insurance plan. By paying a slightly increased premium you can ensure that...

  • Q

    I am 20 years old,I am getting 17+ % or returns from share in my portfolio consistently for the last 6 months.should i think about a career in stockbroking?

    A

    Its nice to note that your portfolio has been gaining such high returns, however it might be too early to take a call and make stockbroking ...

Explore Moneycontrol

Copyright © e-Eighteen.com Ltd. All rights reserved. Reproduction of news articles, photos, videos or any other content in whole or in part in any form or medium without express written permission of moneycontrol.com is prohibited.