Why method of calculation of interest matters when you borrow

Kiran TelangOnce upon a time taking a loan was a taboo in India. ‘Udhaari’ was a bad word. No longer! We have loans available for everything from white goods to weddings to homes. We see the EMI option flashing on our credit card statements for any high value purchase. So a loan is just a phone call away. But not many think about the interest rate calculations, and how much is actually being paid to buy the product. It is necessary to understand how your interest is being calculated in order to pick up a good deal.In a loan repayment there are four factors:1. Principal amount2. Interest rate3. Loan tenure4. Method of calculation of interestWhile the first three factors are clear and mentioned upfront, it is the fourth factor which can make a world of a difference to you. There are essentially two methods of calculation of interest on loans. First is the fixed/flat rate method and second the reducing balance method. Fixed/Flat Rate Method: This method involves calculation of interest on full amount of the loan throughout the tenure of the loan. Let us take an example. Say Ravi takes a loan of Rs.1 lakh for 5 years at 10% rate of interest. In case of a flat rate method, Ravi will pay principal of Rs.20000 every year (100000/5) and interest of Rs.10000 every year (100000*10%). In this manner, he pays an amount of Rs.30000 every year. If you calculate on a monthly basis, he has a payout of Rs.2500 per month. His total interest payment over the tenure of the loan is Rs.50000. The effective interest rate by this method of calculation is actually 17.27% per annum.(Please note that fixed rate method of calculation of interest is not to be confused with fixed interest rate loans)Reducing balance method: If Ravi’s loan was on a reducing balance method of calculation, his payouts would change. In the reducing balance method, the repayments that you make are used to reduce the balance of your outstanding loan. The interest is then calculated on this reduced balance. It can either be an annual reducing balance or a monthly reducing balance.A simple formula to calculate the interest on reducing balance interest rate is:Interest= Interest rate per instalment*Loan outstandingSo for the first year, the interest will be= 10%*100000=10000Second year interest=10%*83621=8362And so on. For the monthly reducing balance method, the same formula can be used for calculating the monthly interest.Thus, the monthly reducing balance will lead to the lowest interest payment. The tables below showing Ravi’s loan calculation if the interest is calculated on annual and monthly reducing basis.The table below summarises the repayment figures for Ravi’s loan using the three methods of calculations:Flat rate method is used in microfinance. Most of the bank loans like the home or vehicle loans use the monthly reducing balance methods of calculation. In case of home loans which are generally high value and long tenure loans, the monthly repayment or the EMI has a higher component of interest and lower principal. That is the main reason your home loan does not seem to reduce at all during the initial few years, in spite of you making your EMI payments regularly. With passage of time the interest component reduces. So when you are scouting for any loan, please ensure that you check what method is used to calculate the interest on your loan. The quoted rate of interest may be the same, but the method of calculation can change the picture. Ask questions, understand and then sign on the dotted line to pick up a good deal.Kiran is a member of The Financial Planners’ Guild , India (FPGI). FPGI is an association of Practicing Certified Financial Planners to create awareness about Financial Planning among the public, promote professional excellence and ensure high quality practice standards.