When you take Home Loan or Car Loan or Education Loan or Personal Loan or Credit Card
Loan for a particular tenor, you need to repay the principal
amount within that tenor but also pay the interest on the loan. It is
important to understand interest calculation methodology. ‘X% p.a.’ Flat
Interest Rate is not same as ‘X% p.a.’ Diminishing Balance Interest
Rate (also referred to as Reducing Balance Interest Rate or Effective
Interest Rate).
Flat Rate of Interest basically means that interest is charged on full
amount of the loan throughout the entire loan tenor. Thus the Flat Rate
does not take account of the fact that periodic repayments, which
include both interest and principal, gradually reduce the outstanding
loan amount.
Let us understand by way of an example. For instance you take a loan of
Rs 100,000 with a flat rate of interest of 10% p.a. for 5 years, then
you would pay Rs 20,000 (principal repayment @ 100,000 / 5) + Rs 10,000
(interest @10% of 100,000) = Rs 30,000 every year or Rs 2,500 per month.
Over the tenure of the loan, you would end up paying Rs 150,000 (2,500 *
12 * 5).
What does Diminishing Balance Interest Rate mean?
In Diminishing Balance Interest Rate method, interest is calculated
every month on the outstanding loan balance as reduced by the principal
repayment every month. EMI payment every month contains interest payable
for the outstanding loan amount for the month plus principal repayment.
On every EMI payment, outstanding loan amount reduces by the amount of
principal repayment. Thus interest for next month is calculated only on
the outstanding loan amount as reduced by the principal repayment this
month.
For example, if instead of 10% p.a. flat rate (in the above example),
interest is charged at 10% p.a. reducing balance rate, EMI amount would
be Rs 2,124.70. You would pay Rs 833.33 as interest in the first month
and Rs 1,291.37 (2,124.70 – 833.33) would be Principal Repayment. For
next month interest will be charged only on reduced principal, i.e.
100,000 less 1,291.37 = 98,708.63. Interest for second month would be Rs
822.57 (98,708.63 * 10% / 12) and principal repayment would be Rs
1,302.13 (2,124.70 – 822.57). Thus over the tenure of the loan, you
would end up paying Rs 127,482 (2,124.70 * 12 * 5).
Which is better?
Undoubtedly Diminishing Balance Interest Rate is better from the
perspective that it is more transparent and signifies the “Effective
Interest Rate”. Flat Interest Rate is generally misleading and is often
used to entice customers with too good to resist offers. Imagine being
offered 5 year loan at only 10% Interest Rate. Sounds good, but may be
on little digging you realize that Interest Rate is quoted on Flat basis
and the Effective Interest Rate (i.e. Diminishing Balance Interest
Rate) is actually 17.27%.
Please use the below link to download excel based calculator to compute
EMI for a given Interest Rate on Flat and Diminishing Balance basis. The
calculator also computes equivalent Diminishing Balance Interest Rate
for a given Flat Interest Rate, and vice versa.
Click here to download: FLAT INTEREST RATE VS DIMINISHING BALANCE INTEREST RATE CALCULATOR.
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