Living with credits is the new normal. Almost everyone around us carries a debt of this or that. It may be a home loan, vehicle loan, personal loan, education loan, and loan against property and gold loan. Actually, availing a loan has become so very easy that we can have one within a few hours. The online lenders have made the loan processing so smooth that we apply for a loan without understanding all aspects of a loan. The loan agents or the bank employees whoever sells you a credit product never shows the dark side of it. The lenders never tell you the detailed conditions of a loan. A few minutes spent on reading this article will help you to escape one of the biggest traps of a loan.  

All the borrowers are well aware of the fact that whatever kind of credit we may avail, we are to return the lent amount to the lender along with applicable interest rate. Today we are going to learn the different ways that a lender can calculate the interest on a loan. Most of the times, lenders will not explain those processes as this is how they can earn a profit which is more than the interest rate. Let us understand how you can make yourself away from landing on the lender’s trap.

The interest on a loan can be calculated in two different ways. The first is the Flat Interest Rate and the second is Reducing Balance Interest Rate.

What is a Flat Interest Rate?

A flat interest rate implies that the interest component on the loan will remain the same throughout the tenure. It means that the interest rate will be calculated on the entire principal amount until the tenure ends. In this process of interest calculation, both the principal and the interest component remains same till the last EMI of the loan. Along with every EMI, a part of the principal amount is paid, but while calculating interest in the flat interest rate the interest is calculated even on the principal amount which has been paid.

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Here is How to Calculate a Flat Interest Rate

Interest Payable per Instalment = (Original Loan Amount * No. of Years * Interest Rate p.a.) / Number of Instalments

Let’s say you have taken a loan of Rs 1, 00,000 with a flat rate of interest of 10% p.a. for 5 (60 months) years, then you would pay:

Rs 20,000 (principal repayment @ 1, 00,000 / 5) + Rs 10,000 (interest @10% of 1, 00,000) = Rs 30,000 every year or Rs 2,500 per month.

In this way, you will pay Rs. 2500 x 60= Rs.1, 50,000. So the effective interest on your loan by paying Rs.2500 per month converts to an Effective Interest Rate of 17.27% p.a.

Going by the calculation above it is shown that while opting a loan on a flat interest rate, the effective interest rate is 1.7 to 1.9 times more than the interest rate on our loan agreement paper.

What is a Reducing Balance Interest Rate?

A reducing balance interest rate is calculated every month on the outstanding loan amount. In this type of interest, the EMI includes interest payable for the outstanding loan amount for the month. After every EMI, the outstanding principal amount decreases. So the interest payable for the next month is calculated on the unpaid principal amount. A reducing balance interest rate is applied in a home loan, mortgage loan, loan against property, loan overdrafts, credit cards etc.

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The Formula for Calculating Reducing Balance Interest is

Interest Payable per Installment = Interest Rate per Installment * Remaining Loan Amount

Let us take the same example of a loan of  Rs 1, 00,000 @ 10% interest rate p.a. for 5 (60 months) years.

In a flat interest rate loan, one has to pay interest of Rs.10,000 every month till the end of the tenure. But in a reducing interest rate loan, the interest on the first month will be Rs.10,000 and the second month it will be Rs.8000 as your outstanding principal amount has become Rs.80,000 after paying the first EMI. In this way every month your interest component in the EMI will come down. A loan on reduced interest rate will end up with paying Rs.1.3 lakhs instead of paying 1.5 lakhs on a flat interest rate.

The Words of Caution

The calculations showed above proof how a flat interest is nothing but a trap. This is just a gimmick by lenders to lure customers into taking a loan while showing only the glossy side of it. Such traps are so deep inside that one will be the trap throughout the loan repayment period while never realizing that he is trapped. When people are in urgent need of money, they don’t have enough time or patience to understand those terms and simple they get trapped by the lenders.

So, whenever it comes to availing any kind of loan, you must spend some time calculating the total amount you are paying for the loan. An online EMI calculator is one of the best ways to find the total payable along with the EMI components. An informed decision on credits will make you skip the trap while saving a quite good amount of money.