There are many banks, NBFCs and other online lenders who promote quick & easy loans on flat interest rates. These flat interest rates have been used as a marketing tool by lenders for tempting a customer by quoting low-interest rates and mislead them into taking a high-cost loan. With such interest loans, borrowers fall into debt.
Satyam Kumar, Co-founder, CEO, LoanTap said, “Under flat interest rates customers generally end up paying 1.7 to 1.9 times higher than the reducing balance interest rates effectively.”
We found a great EMI calculator by moneycontrol.com you can check it out here.
To most of the customers this is an unknown fact and they think they are getting lowest interest rate while what they are doing is opposite of that.
Now, Let us understand flat interest rates and reducing balance interest rate methods and its impact on customers.
Flat Interest Rate Method: Under this method, lenders calculate interest on the original principal amount throughout the loan tenure. Thus, both the interest and principal component in EMI remains the same throughout the tenure.
Illustration: Flat interest rate EMI table for ₹ 1 lakh loan, tenure 1 year at 12% per annum.
Reducing interest rate method: Under the reducing interest method, the outstanding principal amount is reduced by the amount of principal repaid and the interest for the next month is calculated on the reduced outstanding principal amount. Thus, the interest component of EMIs keeps on decreasing with the repayments of EMIs.
Illustration: Reducing interest rate EMI table for ₹ 1 lakh loan, tenure 1 year at 12% per annum.
From the above charts we can now see which loan option is best, Reducing Interest rate or Flat Interest rate?
Naveen Kukreja, CEO and Co-founder of Paisabazaar.com said, “Reducing interest rate method is better from the customer’s perspective as the interest cost in the loan availed in the reducing balance method is significantly lower than the loans availed at a flat rate.”
For instance, if you compare two loans availed in above illustration the interest cost in case of the reducing interest rate method would be around 44% lower than the flat interest rate method.
Gaurav Gupta, Co-founder and CEO, MyLoanCare.in added, “From the perspective of being transparent, reducing rates are always better as they reflect the accurate rate and interest to the borrower. Flat rates can be highly misleading especially if quoted on EMI loans that are the most popular loans nowadays.”
Illustration: If a loan of ₹ 1 lakh was taken for a period of 3 years at a flat rate of 10%, repayable in monthly instalment, you pay an EMI of ₹ 3,611 and your effective interest rate calculated is 17.92%. In this situation, the borrower is easily fooled by taking a high cost loan, wrongly believing it to be a 10% loan.
Let’s now check the key difference between flat rate method and reducing balance method.
Drawbacks of the flat interest rate method: There are indeed some major drawbacks as far as the flat interest rate method is concerned. Amit Prakash Singh, Principal Partner-Mortgages, Square Yards said, “The cost of the loan is much higher than a reducing interest rate loan, interest on the entire loan amount and the outstanding loan amount does not go down.”
Lastly, borrowers do not get the benefits of a reduction in interest rates based on market conditions and have to keep paying the same EMI throughout the tenure.
Word of caution: Kunal Varma, Chief Business Officer & Co-founder, MoneyTap said, “A flat interest rate is a gimmick by lenders to lure customers into taking a loan without actually allowing them to understand what the entire scheme is all about.” Consumers who are usually in urgent need of money fall for it and end up paying higher amounts as interest. It’s a trap indeed!
Finally what should a customer do?
Always ask the lender about the interest rate calculation method before taking a final decision to borrow. Singh added, “You can also spend a little time in the calculation of the total interest payable by multiplying their EMIs by the number of monthly instalment and then deducting the principal amount from this sum. This will help compare loan offerings based on rates of interest and calculation methods.”
Also, always take into account upfront costs like processing fees when you are comparing loans from lenders.