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Lessons: Interest Rate Calculations Made Easy

 

 

Different banks quote their interest rates differently. Some might quote rates with an annual rest, while others may quote rates with a monthly rest. In every case the bank will usually quote the ‘annualised rate’, which is obtained by multiplying the rate per rest period into the number of rests per year. For example: In the case of a monthly rest with 1 per cent interest being charged per month, the annualised rate = 1 per cent* number of months in a year = 12 per cent.

Of late, home loan interest rate has been a concern for many due to its volatile behaviour. Banks and institutions often resort to arithmetical jugglery so as to mask the real rates and show attractive rates. So, it is good to approach a bank armed with the knowledge about different calculations of interest rates.

Interest rates can be calculated at a flat rate keeping the outstanding amount (i.e, the amount on which interest is calculated) constant throughout the loan tenure or at a reducing balance rate, which lowers the outstanding amount as the loan is paid back.

What’s flat rate?
For instance: If you took a loan of Rs 10,000 with a flat rate of interest of 10 per cent over five years, then you would pay Rs 2,000 + Rs 1,000 (ie, 10 per cent of the loan) = Rs 3,000 every year. Over the tenure of the loan, you would end up paying Rs 15,000.

What’s reducing balance rate?
If instead of a 10 per cent flat rate (in the above example), you were charged a 10 per cent annual reducing balance rate, you would pay Rs 1,000 as interest in the first year, Rs 800 as interest in the second year, Rs 600 as interest in the third year, Rs 400 as interest in the fourth year and by the last year you would only pay Rs 200 as interest. That is, over the tenure of the loan you would end up paying Rs 13,000 ie, Rs 2,000 less than you would have paid with the 10 per cent flat rate.

Tip: An X per cent flat rate is always more expensive than an X per cent annual reducing balance rate. So insist that the bank quotes you a reducing balance rate for all kinds of loans.

What’s ‘rest’?
The term ‘rest’ comes into the picture only for reducing balance loans. In a reducing balance loan with each EMI paid, the outstanding loan amount is recalculated. A ‘rest’ is the period in which the bank recalculates the loan amount outstanding based upon the amount of loan paid back through Equated monthly installments, i.e. EMIs. Note that this is also the periodicity of compounding.

Rests can be annual, monthly, weekly and even daily!

Let us understand how the difference in the rest period affects the loan taker.

Annual rest: The bank recalculates the outstanding loan amount at the end of 12 months. That is, even though the borrower pays his EMI every month and the loan balance reduces every month, the outstanding loan amount is not adjusted till the end of the year.

Monthly rest: The bank recalculates the outstanding loan amount at the end of each month. That is, the outstanding loan amount on which the interest is charged goes down every month.

Tip: An X per cent annual reducing balance rate is always more expensive than an X per cent monthly reducing balance rate. So bargain for your loan to be calculated on monthly rest basis.

Let’s look at a simple illustration of annual rest versus monthly rest. Assume two scenarios:
1. You borrow Rs 5 lakh at a 12 per cent annualised interest rate at annual rests
2. You borrow Rs 5 lakh at a 12 per cent annualised interest rate at monthly rests.

 

Annualised interest rate 12 per cent
Loan tenure in months 240
Loan amount Rs 5,00,000
Type of Interest Rate Annual Rest
Monthly Rest
Number of compounding periods 20 240
Interest rate in each compounding period 12 per cent 1 per cent
EMI Rs 5,578 Rs 5,505
Total interest paid Rs 8,38,788 Rs 8,21,303

As detailed above, it is clear that you would end up paying less as interest with a monthly rest than you would with an annual rest. That is, you will always pay more interest on an X per cent annual rest rate than you would on an X per cent monthly rest rate.

Tip: Different banks quote their interest rates differently. Some might quote rates with an annual rest, while others may quote rates with a monthly rest. In every case the bank will usually quote the ‘annualised rate’, which is obtained by multiplying the rate per rest period into the number of rests per year. For example: In the case of a monthly rest with 1 per cent interest being charged per month, the annualised rate = 1 per cent* number of months in a year = 12 per cent.

To compare loan offers from multiple banks, you need to calculate the total amount of interest you would pay for each offer. This will enable you to compare offers even if their interest rates are quoted differently.

Source: Bank Bazar

By vayaM CS