For the twins Gayathri and Sanjana, fate intended that everything in their lives should happen in unison. Be it their first visit from the tooth fairy or their first job, the precision in timing was astounding. It so happened that they decided to buy their first car around the same time.
Gayathri approached the first friendly bank that treated her like a queen, applied for a loan and took their best offer. Sanjana, on the other hand, researched every loan offer she received from several banks.
Back at home, the sisters compared notes. To Gayathri’s joy, it looked like she had landed on an excellent bargain with minimum fuss. For a loan amount of Rs 10 lakh with a 5-year tenure, she had an annualized interest rate of 12.75 per cent, while the two loans that Sanjana had shortlisted were both quoted at an annualized interest rate of 13 per cent! However, Gayathri's joy was short-lived when Sanjana explained how the loans works:
Gayathri obtained a flat rate loan. Sanjana, on the other hand, had shortlisted two reducing balance loan offers with different rest periods. But, what's the difference between the two?
Flat rate: The interest rate is calculated keeping the outstanding amount constant throughout the loan tenure.
Reducing balance loan: The interest rate is recalculated on a periodic basis based of the reducing outstanding loan amount.
Reducing balance loan has other significant factors that impacts the loan cost, such as time interval at which the reducing balance is recalculated. This could be daily, monthly, quarterly, half yearly or yearly. These time periods are known as rests, which denotes the regular interval at which the loan amount balance is recalculated.
Some calculations to help Gayathri understand the real cost of her loan:
As per the above calculations, Gayathri will need to pay Rs 6.4 lakh as interest, while Sanjana will pay around Rs 2.7 lakh (Rs 6.4 lakh - Rs 3.7 lakh) lesser than her sister!
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How do you calculate the total amount of interest payable?
Your EMI x the number of monthly installments less the loan amount
That is, say, Rs 27,292 x 60 months - 10 lakh = Rs 6.4 lakh
from this figure. You can then easily identify which loan is the most cost effective for you. Remember to account for any upfront fees (eg, processing fee) while comparing two loans.
Choosing the offer with the ideal ‘rest’
To make the most of your reducing balance loan, you need to ensure the periodicity of repayment closely matches the frequency of your rest.
Sanjana realised that annual rest means she will pay interest on the entire loan amount till that particular year ends, even when the outstanding loan amount reduces each month. While in a monthly rest, the balance loan amount is recalculated and decreases every month.
So, what’s best for you? If you are repaying your loan amount on a monthly basis, take up the loan offer that gives you the best rate on a monthly rest. Sanjana will choose the loan with the rest that more closely matches the frequency of her loan repayment.
Abitha Deepak is Head of Content & Research at BankBazaar.com - An online marketplace where you can instantly get loan rate quotes, compare and apply online for all your personal loan, home loan and credit card needs from India's leading banks and NBFCs.
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