It is better to understand the jargon associated with interest rates on loans. This will help you to know how much interest you actually pay.
OF late, home loan interest rate has been a concern for many due to its volatile behaviour. Banks and institutions often resort to arithmetical jugglery so as to mask the real rates and show attractive rates. So, we suggest you approach a bank armed with the knowledge about different calculations of interest rates. wealth explains these calculations in detail.
Interest rates can be calculated at a flat rate keeping the outstanding amount (ie, the amount on which interest is calculated) constant throughout the loan tenure or at a reducing balance rate, which lowers the outstanding amount as the loan is paid back.
What's flat rate?
For instance: If you took a loan of Rs 10,000 with a flat rate of interest of 10 per cent over five years, then you would pay Rs 2,000 + Rs 1,000 (ie, 10 per cent of the loan) = Rs 3,000 every year. Over the tenure of the loan, you would end up paying Rs 15,000.
What's reducing balance rate?
If instead of a 10 per cent flat rate (in the above example), you were charged a 10 per cent annual reducing balance rate, you would pay Rs 1,000 as interest in the first year, Rs 800 as interest in the second year, Rs 600 as interest in the third year, Rs 400 as interest in the fourth year and by the last year you would only pay Rs 200 as interest. That is, over the tenure of the loan you would end up paying Rs 13,000 ie, Rs 2,000 less than you would have paid with the 10 per cent flat rate.
Tip: An X per cent flat rate is always more expensive than an X per cent annual reducing balance rate. So insist that the bank quotes you a reducing balance rate for all kinds of loans.
The term 'rest' comes into the picture only for reducing balance loans. A 'rest' is the period in which the bank recalculates the loan amount outstanding based upon the amount of loan paid back, and it is also the periodicity of compounding.
Rests can be annual, monthly, weekly and even daily!
Let us understand how the difference in the rest period affects the loan taker.
Annual rest: The bank recalculates the outstanding loan amount at the end of 12 months. That is, even though the borrower pays his EMI every month and the loan balance reduces every month, the outstanding loan amount is not adjusted till the end of the year.
Monthly rest: The bank recalculates the outstanding loan amount at the end of each month. That is, the outstanding loan amount on which the interest is charged goes down every month.
Tip: An X per cent annual reducing balance rate is always more expensive than an X per cent monthly reducing balance rate. So bargain for your loan to be calculated on monthly rest basis.Get access to India's fastest growing financial subscriptions service Moneycontrol Pro for as little as Rs 599 for first year. Use the code "GETPRO". Moneycontrol Pro offers you all the information you need for wealth creation including actionable investment ideas, independent research and insights & analysis For more information, check out the Moneycontrol website or mobile app.