It has become common these days to get a call from loan officer of a bank to pursue you to take a personal loan. It might sound tempting when the loan executive says “these loans are exclusive for you offered with attractive fixed low interest rate”.
Before getting too excited for it, understand there is a catch! Do you know a borrower ends up paying more money on interest to bank on a fixed interest rate loan?
They attack on the ignorance of an average customer.
Bank offers loan in two methods – a) Fixed interest rate b) Reducing balance loan.
Fixed interest rate:
In fixed interest rate method , interest rates charged will be low compared to reducing balance method loan.
But you would be paying more interest to bank, even with low interest rate. How?
In fixed interest rate method, the EMI will be calculated on opening loan balance. Even if you pay your monthly EMI, the interest you pay doesn’t go low.
Hence the EMI you pay would remain constant during your loan tenure. So Fixed interest rate loan becomes costly.
Here the interest calculation is simple and straight forward. Lets say take you a take loan for 100,000 INR with 8.5 % (Fixed interest rate) for one year (12 months).
Calculation: Fixed interest rate method
Do you notice how the interest remains same from starting to end of loan tenure. Why?
In fixed interest rate method, the interest calculation is done based on the loan balance in begining.
No matter if the loan balance gets reducing as the EMI’s begin paid, but the interest paid remains the same.
Related article: How to be debt free in 2022?
Reducing balance loan:
In reducing balance method loan, the interest rate calculation is done on monthly basis.
So calculating the interest rate on this method becomes complicated.
As loan outstanding reduces each month, hence the borrower pays less interest amount as each month passing by.
So reducing balance loan is more pocket friendly for the borrower as he/she ends up paying less interest amount to the bank.
To understand this , lets take a simple example.
Lets say take you a take loan for 100,000 INR with 8.5 % (reducing balance method loan) for one year (12 months).
Calculation: Reducing balance method
Did you notice how interest load gets reducing each month. Why?
This happens because interest calculation is done based on “loan balance” available at that month.
As loan balance reduced every passing month, the interest on loan is reduced accordingly.
Verdict: Loan amount take is same, Interest rate is same, even loan tenure is same. But we paid way less interest on reducing balance method.
This type of loan is more borrower friendly than the fixed interest rate loan.
What if the interest rate is higher in Reducing balance method loan?
Usually, banks keeps the interest rate of fixed rate on a lower side & keeps the interest rate of reducing balance method loan on a higher side.
It appears to borrower, going with fixed interest rate makes sense than higher rate reducing balance method. Less he knows and took the bait.
But ironically , the borrower ends up paying the same interest rate despite of high interest rate in reducing balance method.
Next time, when you get a call from bank for personal loan, be sure to dig about whether its a fixed interest rate loan or reducing balance loan.
At the end, the reducing balance loan is more economical to a borrower as he pays less interest on his loan to the bank.
If you have any queries or thoughts, please do let me know in comments. Thank you for stopping by.