Loan seems cheap? Check interest outgo

You are scouting for the cheapest loan for your Diwali shopping and come across a lender offering rates much lower than others. You quickly calculate the Equated Monthly Installment (EMI) and decide it is the best option for you. But before you thank your stars check what will be the interest outgo during the whole tenure of the loan. Chances are that the cheap loan is a flat rate or a fixed rate loan.

Fixed balance/flat rate and reducing balance are two common methods usually opted by lenders to calculate interest on the loan. While most loans today are offered on a reducing balance basis, some fintech players offer short-term personal loans on a fixed rate basis. Borrowers must be aware of what they are getting into before locking into the loan.

Flat rate versus reducing balance loan

The basic difference is that flat rate loans are calculated at on the same principal amount of the loan throughout the loan tenure. While calculating your EMI, the principal amount on which the interest is calculated remains constant. "This method does not factor in the gradual reduction in the principal amount upon repayment of EMIs. So, even though you are repaying part of the outstanding principal each year through EMIs, your interest would continue to be calculated on the original principal amount,'' says Naveen Kukreja – CEO & co-founder, Paisabazaar.com.

On the other hand, reducing/diminishing balance method involves interest calculation on the principal balance outstanding, and the outstanding principal amount keeps reducing upon EMI payments. "In a reducing balance loan, you pay interest only for the outstanding loan amount and not on the original principal amount through the tenure. Lenders usually practice either monthly or daily reducing balance method,'' Kukreja says.

The difference will be visible when you check your EMI statement. "In a reducing balance loan, initially the component of the EMI that goes towards repayment of principal amount is lower, while the component that goes towards interest repayment is higher. As the loan matures, the proportion of repayment towards principal increases, while the interest component reduces. While in flat rate loan, the principal and interest component will be exactly in the same ratio throughout the tenure,'' explains Sreemoyee Mukherjee, head - unsecured loans, BankBazaar.com.

What to watch out for

While opting for fixed balance/flat rate loans, make sure to check its effective rate of interest to enable a proper comparison of rates. The interest quoted on flat rate loans would be lower than the effective interest rate and hence, would not clearly reflect the actual interest cost of the loan. Reducing balance method is better from the customer's perspective due to its lower interest cost.

"Since most lenders have opted for reducing balance method to compute interest rates on loans, the market for flat rate loans has narrowed. However, a few fintech lenders are providing loans such as small business loans and short-term personal loans at flat rates,'' Kukreja says.

Since flat rates are offered by the lender as a feature/part of their loan scheme, the customer/borrower usually does not have the option of choosing between flat rate and reducing balance method.

Most lenders, whose rates are in line with the market, would offer monthly reducing balance loans. But some fintech players do offer a flat rate on short-term loans to artificially show a lower rate, says Satyam Kumar, co-founder, LoanTap. "The actual rate is higher than what is communicated in case of flat rate. That is something you should always look at,'' he adds.

Lenders don't usually use the fixed rate regime to compute interest. They use the reducing balance rate method. They, however, prefer to advertise the flat interest rate, as the flat rate is generally lower than the effective interest rate (effective interest rate signifies the actual interest on the loan), says Aditya Kumar, founder and CEO, Qbera.com.

"On a flat interest rate of 10% for a given loan, the effective interest rate is usually about 15% or higher, depending on the loan tenure (and the flat rate itself),'' he explains.

Always check the repayment schedule as it will have the break-up of the principal and interest. Besides, if you want to pre-pay, it is possible in the case of reducing balance loans, but may not be of much help in case of flat rate loans.

"In monthly reducing balance you are typically allowed foreclose. But in flat rate loans, whether you foreclose or not, there is no impact because interest has already been calculated,'' says Kumar of LoanTap

The only advantage of a flat rate is, perhaps, that since the loan tenure is usually longer, it allows borrowers to spread their repayment over a more extended period, says Bala Parthasarathy, co-founder & CEO, MoneyTap. This can help those who have tight budgets and cannot afford too much variation in their monthly expenses.

"If the loan tenure is high, reducing balance interest will save you money. But if longer tenure is not available, and the customer cannot repay the loan within a shorter period, a fixed interest loan with a longer tenure could be a more suitable option,'' Parathasarathy says.

"Fixed rate will only seem lower than reducing balance because you are paying on the entire balance. But irrespective of what lenders offer, borrowers must calculate and check what it means in terms of reducing balance and then compare it with what other players offer,'' Mukherjee says.

HOW MUCH ARE YOU PAYING

• In fixed or flat rate loans the EMI is calculated on the same principal amount throughout the entire loan tenure
   
• In reducing balance loans the EMI is calculated on the outstanding principal amount, which keeps reducing as the borrower repays
   
• Lenders quote a lower interest rate on fixed rate loans, but over the entire loan tenure the borrower ends up repaying more