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

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:Bankbazaar)
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