Often financial institution gives competitive rates to attract customers for loans, which can be a business loan, home loan, education loan, or a vehicle loan. When you receive such offers you should first analyze and know the EMI amount and the methods to calculate it. EMI is calculated by two processes – Fixed interest rate method and reducing balance method. The method of calculating the EMI and interest should be essential in deciding the lender.
Let us understand this better with an example for the two methods of interest calculation – fixed/simple interest calculation method and reducing the balancing method.
The loan worth is Rs. 25,00,000
Loan Tenure is 1 year
Rate of interest is 12%
Here the interest is calculated on the principal amount, which is Rs.25,00,000. The interest calculated for the entire tenure of loan which in this case will be Rs.3,00,000. The interest calculated is then added to the principal i.e. Rs.28,00,000. This will further be divided into 12 equal parts to arrive at your monthly EMI, which comes to be Rs.2,33,333. The total interest is thus Rs.3,00,000.
Let us use the same loan amount, interest rate and loan tenure, to find out the EMI amount, according to the reducing balance method. The EMI we come to is Rs.2,22,121. In reducing balance method calculation, the amount you pay towards your monthly EMI gets reduced in that principal part. The interest is then determined on the rest of the amount and you will have to pay that for the month. Here the principal will not be constant. It decreases slowly and consistently monthly, and at the end of the 12th month, the principal will amount to zero. During the initial stages of the loan, the major part goes in interest payment and the smaller part goes towards the principal.
Among the two different methods, the fixed interest calculation method demanded a total of Rs.1,34,537 higher interest than the reducing balance method. Hence, it is of utmost importance to know the interest calculation method, and not just the interest rate offered. Make sure that you ask the loan provider the detailed difference in interest payment, and only then decide to avail the loan.
• The interest amount is calculated based on the initial principal amount, so the sum to be paid is consistent.
• The monthly installments paid does not change with time.
• The customer is offered a lot of flexibility in terms of the loan repayment tenure in order to match their repayment capacity.
• It usually has a low-interest rate, which increases the amount of loan eligibility of the customer.
• The risk associated with this loan is considerably less which offers a lot of peace of mind to the borrowers.
• EMI amount for payment is higher in comparison to other schemes, which is a major drawback.
• Once you have decided to go for this loan, you will have to continue paying the same interest rate until you go for refinancing.
• The loan repayment tenure is comparatively longer.
It is understandable for a customer to get confused while choosing the type of loan that will best suit his or her needs while paying the least amount possible as interest. Take a look at these details-
• Normally, the interest rate offered for Fixed Interest Loans is lower than that of the Reducing Balance Loans.
• Calculating the amount of interest payable for a Fixed Interest Loan is simpler, in comparison to the Reducing Balance Loan.
• The interest charged for a Fixed Interest Loan is calculated based on the initial principal amount of loan borrowed by the customer and does not change throughout the loan tenure. On the other hand, for a Reducing Balance Loan, it is gathered based on the outstanding principal amount at varying intervals.
• As the interest paid for the Reducing Balance Loan minimizes over time, the amount of interest paid is usually less compared to a Fixed Interest Loan.
• Due to a lower interest amount that needs to be paid by the borrower, the Reducing Balance Loan is better than the Fixed Interest Loan in a real-time scenario.
• The loan tenure of a Fixed Interest Loan is usually stretched out for a lengthier duration than that of the Reducing Balance Loan.
Though loans are readily offered, it’s your hard-earned money for which you should first check all details for loans online and the method applied for calculating the interest, then opt for the one best suited.