Taking a personal loan in present times has become an extremely easy task, especially with the emergence of Fintech lending startups that have, through technological prowess, greatly simplified the loan process to make it way more efficient, seamless and convenient. If you’re deciding to take a personal loan, the most essential aspect to consider is the rate of interest, as your ROI is what determines your cost of borrowing.
The market houses multiple lenders, each offering loans at varied interest rates. While top private banks are usually known to offer the most economical interest rates, certain P2P lenders claim to offer lower rates - an aspect that when closely looked at, seems incorrect. This is where the two types of rate structures associated with personal loans have to be understood, mostly to ward-off being hoodwinked by certain lenders.
What are the type of rate structures linked to personal loans?
The two rate structures are the Flat Rate structure and the Reducing Balance Rate structure (also known as the Effective Interest Rate or EIR). Both these structures work differently, and each computes interest in a certain way. The question of which of these interest rates to pick isn’t essentially the borrower’s choice, it is the lender’s decision. But if the borrower were to be given a choice, let’s try and find out which of these rate structures work better in reducing the cost of borrowing.
The flat rate structure
In the flat rate structure, interest on your loan is calculated by considering the entire principal and associating the annual rate of interest with it. Let’s say you want to take out a loan for Rs. 1,00,000 from a lender at a flat interest rate of 12% p.a. for a period of 2 years. Under the flat rate structure, the annual interest rate is directly applied to the principal. Meaning the interest you’d be paying in this case is - Rs. 24,000 (annual interest of 12,000 x 2 (tenure)). Seems simple and straightforward, doesn’t it?
The reducing balance rate structure
Under the reducing balance rate, the interest is computed differently – apart from considering your loan principal and the rate, it also takes into account your monthly repayments. As and when you keep making repayments, interest in accordance with the annual rate is levied on the remaining balance. Meaning, interest is technically levied on a monthly basis as and when you keep making repayments.
Let’s say you take out a loan of Rs. 1 lakh under the reducing balance rate structure at an interest rate of 12%. After your EMI is determined and you make your first monthly repayment, interest is calculated on the remaining balance and levied. This goes on until the entire balance is cleared.
Which of these rates should you opt for?
An important thing to note is that most lenders use the reducing balance rate to compute the interest you’d be paying towards your loan. As such, lenders don’t compute interest under the flat rate method, as the interest under this method is much lesser when compared to the reducing balance rate.
Don’t get wooed by lenders claiming to offer ridiculously low rates of interest, especially on unsecured loans. For all you know, this might be the flat interest rate and not the reducing balance rate, and it is the reducing balance rate that reflects the real cost of borrowing, and of course, the interest amount accompanying your loan. If we were to quantify the difference, a rate of roughly 8% under the flat rate structure amounts to a real rate (under the reducing balance rate) of about 15% p.a.The writer is Founder & CEO of Qbera.com