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Understanding the interest rate

When you are faced with a loan, the first issue to cross your mind would be the interest rate. However, just because two players are offering loan at an identical rate of interest, it does not necessarily mean that the cost of the loan is alike in both cases. On the other hand, if one is offering a slightly lower interest than the other, it need not indicate that the lower interest loan is a cheaper option. Welcome to the intricate world of interest rate calculations.

Annual, monthly or daily?
What on earth is that? In the above words lies the key to knowing whether or not you are getting a cheaper deal. Interest rate is calculated either on an annual-reducing, monthly-reducing, or daily-reducing basis.

Daily reducing basis means that the moment you make a payment, the very next day the interest is calculated on the balance principal. This will now be lowered since you have paid an amount. So, if you are being charged an interest on a principal of, say, Rs 10,000 and you repay Rs 3,000 today, the interest rate will change from tomorrow and be calculated on the balance Rs 7,000.

Monthly-reducing basis means that principal amount you pay every month is deducted when calculating the interest rate for the following months. So, the interest rate will change only next month and be levied on the balance Rs 7,000.

Annual-reducing basis means that the total principal repaid by the end of the year is deducted when calculating the interest rate for the next year. Here, you continue paying interest on Rs 10,000 till the end of the year.

Calculations on a daily-reducing balance are done mainly on credit cards whereby whenever a payment is made, the principal is immediately deducted. In the case of monthly-reducing balance, it takes place the next month and in the case of annual-reducing basis, the next year. The thumb rule: the more frequently computed, the better.

What's a 'flat rate' then?
In a nutshell, it is the most expensive loan you can ever take. But no player will calculate the rate of interest on a flat basis. Yes, they may state the flat rate of interest as it appears low: but that's just to trap you. So, when presented with the flat rate, ask for the method of calculation (which is either on an annual, monthly or daily basis).

If a flat rate of interest is given, the effective rate works out to be much more. For example, assume you have taken a loan of Rs 1,20,000 and you repay Rs 40,000 every year. The interest calculation on an annual-reducing basis will be on Rs 1,20,000 the first year, Rs 80,000 the next year and Rs 40,000 the third year. If it is the monthly-reducing loan, the amount of interest to be paid will drop the month after you make a payment. However, if it is a flat rate of interest, then you pay interest on Rs 1,20,000 every year. No principal deduction is taken into account.

Let's put some figures to this. Assume you take a loan of Rs 85,000 for two years and the financier gives you a flat rate of interest of 9 per cent with an equated monthly installment (EMI) of Rs 4,179. On an annual reducing basis, this loan works out to 11.77 per cent and on a monthly reducing basis, 16.41 per cent.

What about two identical rates?
That can be misleading, too. Let's work that out. Two players offer you an identical rate of interest for the identical amount and identical repayment tenure. No need to toss a coin to make your choice. Just check out the method of computation: annual- or monthly-reducing basis? This difference will show up in your EMI. In the example below, with all factors identical except for the method of interest calculation, you can have savings of Rs 12,000 at the end of five years.

Does it apply to a cheaper rate too?
Yes, again. Just because someone is offering you a lower rate of interest, does not mean that the loan is cheaper. Here, too, the only way that you will be able to fathom this is by asking for the EMI. It would be interesting to note that even at a lower rate of interest, the EMI works out to be more because of the way the interest is calculated. In the example below, the apparently higher interest rate gives you savings of Rs 36,900.

Will the difference matter over long stretches of time?
Not much, actually. The interest rate calculation matters most if the loan is for a short tenure of a couple of years. The effect is nullified when one goes on to longer repayment tenures. So, if speed is of essence and the finance company with an annual-reducing balance is offering you a quicker processing time vis-a-vis one with a monthly-reducing balance payment, you can afford to ignore the difference in calculation. Especially, if your repayment tenure stretches for a number of years. In the example below, you save around Rs 12,000 in five years, but just Rs 9,094 in 15 years.

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