Taking a loan involves a lot of background work and research. One has to focus on a lot of aspects before deciding from where to borrow and how much to borrow. Whether one were to compare home loans or personal loans before choosing one, the focus is usually the maximum on the interest rate at which the loan is available as that decides the borrower’s monthly outflow of interest and the total interest burden over the years. The interest burden for a loan is dependent upon the principal amount, interest rate, the loan duration and another factor that may often be ignored; the interest calculation method.
How is Interest Calculated?
Loans are repaid in equal monthly installments and the principal is used as the base to calculate the interest outflow; one can use a loan interest calculator to find out about the monthly outflow in case of a loan. Each EMI has a principal component and the interest component. Lenders may calculate interest on the loan principal on two ways; it could be the Fixed/Flat rate or the Reducing Balance Method. Let us understand the difference between both methods and their implication.
Fixed or Flat Rate Method:
As the name signifies this is a method that calculates interest on a flat rate. The interest is calculated keeping the principal as constant throughout the loan tenure .So if one were to borrow Rs. 10, 00,000 at 11% for 15 years then the principal (for the purpose of interest calculation) will remain the same throughout the loan tenure. The interest would be calculated on Rs. 10, 00,000 as principal for 15 year regardless of the repayment that is made towards the principal each month.
Reducing Balance Method:
Again the name of the method gives us a hint how the interest is calculated here. Here the interest is calculated on the reduced principal amount. Thus when you pay the first installment the principal portion from the EMI amount is deducted from the original borrowed amount and the interest is calculated on the remaining principal. This continues with every subsequent loan repayment.
Reducing balance method can also be calculated in three way; annual reducing, monthly reducing and daily reducing. In the annual reducing method though the installments are paid each month the adjustments for principal and interest are made yearly only. In monthly reducing the principal is adjusted each month, i.e with each EMI. Thus the interest is calculated on the reduced EMI each subsequent month considering the payment made in the prior month. In the daily reducing method the adjustment would be made per day but that would mean paying an installment per day and not per month which might not be so practical.
Which Calculation Method is Better?
Obviously the fixed rate method can be said to be the least friendly for the borrower as the amount repaid towards the principal is not taken into account thus making the actual cost of borrowing higher for him/her. The principal remains same throughout for calculation purpose despite the borrower paying a part of the principal with each installment. Thus the effective rate of interest on the loan keeps rising for the borrower as the principal keeps reducing with every monthly installment.
When we come to various ways for calculating the reducing balance method then obviously the daily reducing would be the best from a borrower’s perspective but it is practically not possible as the payments are made monthly. Annual would also not be in the favor of the borrower who pays monthly but enjoys the benefit only annually. Then we come to the monthly reducing method for calculation; here the borrowers repays monthly and the adjustment towards the principal are made simultaneously making it the most user friendly rate calculation way. Most advertised car loan rates and personal loan rates are on monthly reducing balance.
However it is important mention here that flat or fixed loan rates are lesser than the reducing balance loan rates thus making the actual difference for the borrower less between the total loan costs. Calculating interest on fixed rate loans might be easier for the borrower but the borrower rarely has to do that, there are amortization tables and calculators available online which take care of it for you. So yes interest rates as well as the interest calculation method are important when it comes to borrowing. Make sure you get clarity about the interest calculation method that will be used to calculate the interest.