Fixed vs reducing balance interest rate Personal loan

Fixed v/s reducing balance interest

Another area where a lot of people are faced with difficulty is the manner in which the interest rate is calculated. The normal human tendency is to opt for a rate that is lower because this seems to suggest that the burden on a borrower will be less. But this is not always the case because a person can end up paying a higher amount of interest even when the rate of interest on the loan is lower than some other loans. This has to be considered carefully, and a decision about selecting a particular personal loan or rate of interest should be made only after a proper analysis of the entire position.

The trick lies in the nature of the calculation of the rate of interest. There are two major ways of calculating the interest rate. The first is the flat rate, also called as fixed interest rate. This is a very simple method and hence is preferred by many. The percentage of the rate is calculated on the principal amount of the loan, and this is done for the entire time period for which the loan is taken. For example, if the rate of interest on a flat basis is 10% on a loan of Rs. 2 lakh that has to be repaid over a period of 3 years then the interest that the borrower will have to pay is Rs. 20,000 for each of the three years amounting to a total of Rs. 60,000. The interest figure along with the capital is then distributed over the entire repayment period to arrive at the amount of equated monthly installment (EMI). Though this method is very simple, its major drawback is that the impact of the repayment of the capital is not considered at all in the entire interest working.

This drawback is tackled by the other interest calculating method that is the reducing balance. Here, interest rate is charged only on the outstanding amount of a loan. In this case the interest rate is higher than the flat rate. But unless the entire loan repayment amount is worked out, a person will not be able to know which rate is better in terms of a lower interest payment. Every month when the EMI results in a payment the capital portion is deducted from the total loan taken and then the remaining amount is charged an interest at the applicable rate. In this way, there is a gradual reduction of the capital and consequently of the base on which the entire interest working is done. Due to this reason, many people prefer a slightly higher rate loan that is reducing balance in nature because they know that the cost will be lesser than what they would bear in case of a flat rate loan.

Every borrower must always ask the question about the nature of the interest calculation on the loan before making any decision.