It is common that a person while going to a bank for the loan would expect good interest rates and when the bank offers them attractive interest rates, they accept it. But there is an important aspect that needs to be given light on is the total EMI that the customer would be paying on the loan at that interest rate. Basically, there are two methods of calculating EMI- Fixed/Flat interest rate method and Reducing interest rate method. EMI varies in different methods so it’s important to consider both the methods and then choose one.
Fixed interest rate method
Fixed interest rate method means the interest rate calculated on the full amount of the loan throughout its tenure without considering the fact that the principal loan amount decreases every month. The EMI paid under this method is a summation of interest calculated on the principal loan amount plus monthly instalment. The formula used for calculating interest under this method is:-
Interest payable per instalment = (Original loan amount * Number of years * Interest rate per annum) / Number of instalments
This method is generally used to calculate interest payable on vehicle loans, personal loan. This method is not used much because of its impractical nature. The interest amount doesn’t decrease even after paying few instalments; you still have to pay interest on the same loan amount and not on the outstanding amount. Eventually, the interest rate increases 1.5-1.7 times more when calculating effective interest rate equivalent.
Reducing Balance interest rate
Reducing Balance interest rate method means interest is paid on the outstanding amount and not on the principal loan amount. The EMI paid under this method is a summation of monthly instalment plus interest calculated on the outstanding amount. The formula used for calculating interest under this method is:-
Interest Payable per Instalment = Interest Rate per Instalment * Remaining Loan Amount
This method is generally used to calculate interest payable on housing, mortgage, property loan, credit card and overdraft facilities. The interest rate paid in this method is the effective interest rate.
Difference between Fixed and Reducing balance loan EMIs:
- In fixed loan EMIs, the interest rate is calculated on the principal amount of the loan and it is comparatively lower than the latter. On the other hand, the interest rate is calculated only on the outstanding loan amount on monthly basis in the reducing balance rate method.
- Calculating flat interest rate is easier as compared to reducing balance rate in which the calculations are quite tricky.
- In practical terms, the reducing loan method is better than the fixed rate method and EMIs are comparatively lower in Reducing balance loan method.
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