It is important to check while finalizing the Bank/NBFC who is giving an affordable interest rate as per the requirement of the borrower. One has to be cautious in not only understanding the EMI amount but also the mode of its calculation. EMI can be calculated by Fixed Rate Method, Floating Rate Method and Reducing Balance Method. Be careful to choose a lender not only from interest perspective but also attach the utmost important factor of EMI and interest calculation.
Interest is an extra amount over the principal amount repaid to the lender. Each EMI repayment has a portion paid towards the principal amount and the quantity of it goes towards the interest. Reducing Balance Rate of Interest is also known as Diminishing Rate of Interest.
The reducing rate of interest calculation concludes that the payments are made on the principal amount of the loan and the interest payment reduces as well. The interest amount is calculated every month based on the outstanding loan amount. The EMI includes the interest payable and the principal repayment for the outstanding loan amount. After the repayment the outstanding loan amount gets reduced. Hence, the interest for the next month is calculated only on the outstanding loan amount.
This method is used in almost every kind of a loan available in the market. In this method the interest is calculated on the outstanding amount. Before moving ahead lets understand the above method with an example:
Mr. Anang availed a car loan of Rs. 4,00,000 for 7yrs at the rate of 8.95%. He choose the Reducing Rate of Interest calculation method. The car was purchased in December and the EMI’s started calculated from January. Hence the following table specifies the breakup amount of principal and interest per EMI for first 12 months. (Know More About Factors effecting loan EMI)
In the above table if the interest is charged in a reducing mode instead of flat rate at the rate of 8.95%. The EMI would be Rs. 6,425. The calculated Interest amount for the first month will be Rs. 2,983 and 3,442 will be calculated towards the Principal repayment. For the Reduced Principal Amount i.e. 4,00,000 – 3,442 = 3,96,558. Interest to be calculated for the next month will be Rs. 2,958 (3,96,558 * 8.95% / 12) and the Principal repayment will be Rs. 3,468 (6,425 – 2,958) and this continues…
Undoubtedly, the reducing / diminishing rate of interest is always a better idea to choose. The perspective behind is that it is more transparent and provides a detailed “Effective Interest Rates”. The other modes like fixed or floating are generally misleading to attract the customers with irresistible offers. Just imagine, if a Bank/ NBFC lends a loan for 5 years only at the rate of 10%. Sounds too lucrative, but if we do a little research then we will realize that the Interest rate was quoted on a Flat Rate basis and the Effective Rate (Reducing / Diminishing Rate) is actually 17.27%.