Fixed Vs Reducing Balance Loan EMIs

Getting a loan is very easy these days. Banks offer different types of loans such as Personal Loan, Home Loan, and Car Loan to help you meet your diversified individual requirements. Not only getting a loan is easy, paying it back is also equally affordable. You can pay off your principal as well as interest component on the principal with the help of equated monthly installments (EMIs). When you apply for a loan and your loan application is approved, your bank may apply two methods of calculating interest payable on the principal amount; they either charge fixed rate method or a reducing balance method to calculate interest.  Fixed rate and reducing balance rate are two common types interest rates charged on your loans.

Know about fixed and reducing balance interest rates

In fixed or flat rates, banks calculate interest keeping the outstanding amount fixed throughout the whole loan tenure. This method is normally used to calculate interest payable on personal loans. Interest is calculated on the full amount of the loan for the entire tenure without taking into account the fact that the monthly EMIs gradually reduce the principal amount of the loan.

But in reducing balance method, interest rate is calculated based on the reduced outstanding loan amount. Instead of charging a fixed and equal amount of interest  every year or month, the reducing balance method charges interest on the remaining balance of your loan. Normally, banks use this method of calculation to calculate interest payable on property loans. After every EMI payment you make, your original loan amount gets reduced and interest for the next month is calculated only on the reduced outstanding amount. So, your principal loan amount will not be static in this method. It gradually decreases. In reducing balance method, your EMIs will include interest payable for the outstanding loan amount for the month along with repayment towards the principal amount. You can calculate reducing balance monthly loan EMIs by using an EMI Calculator and putting the following information in it -  the rate of Interest, loan amount, loan tenure and whether you choose annual, monthly or daily reducing balance for the calculation. Once, you put all these details, the calculator will instantly reveal the amount of monthly EMIs.

Difference between fixed and reducing balance methods of interest calculation

The two methods of interest calculation, fixed rate and reducing balance rate, function differently. Mentioned below are some of the difference between both:

• In the fixed rate method, banks calculate interest on your monthly EMIs keeping the outstanding amount fixed throughout the entire tenure of your loan. But, in the reducing balance method, the interest rate on your monthly EMIs is calculated based on the reduced  principal  loan amount.
• It is easy to calculate flat interest rate compared to reducing balance interest rate.
• With the reducing balance method, you will pay less interest than you would pay with a fixed rate scheme.
• The reducing balance method is a better idea than flat rate method, if your monthly income is expected to fall down.

Which method of interest calculation should I choose for loan EMIs?

No matter, which method you choose to pay interest on your loans, it is important you know about these two methods of deducting interest on loans. Also, you should have a clear idea about which method your bank is using to calculate interest on your loan. Normally, banks offer very attractive interest rates on fixed rate loans. But, don’t always look at the interest rate part of your loan. You should also consider the method of calculating interest on it. Many borrowers don’t prefer to go for flat rate loan EMIs because even if you pay off your loan, your interest amount does not reduce. But, in case of a reducing balance interest rate loan EMI scheme, your interest amount goes down as you make payment towards your principal amount. But, the only problem you may face with the reducing balance method is that you may end up paying higher payments in the initial period of loan repayment.

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Follow These Rules While Taking a Loan

Do you have a job that you think spays you well but, you realise that it is not enough as there a lot of things that you can’t afford to buy? Well, it is a story of all our lives. This is where the banks and financial institutions benefit from and offer us loans to help us meet our ends. But, do these banks really help us or just helping themselves?

If you have taken a home loan, car loan or a personal loan, the EMI of all these loans can’t be more than 50% of your income. The loan to income ratio is the total EMI divided by the net monthly income multiplied by 100. The comfortable loan to income ratio is 20-25% anything above it is to be dealt with caution. Follow these rules and help yourself from being enslaved by debt.

Borrow money that you can repay:

Don’t live beyond your means. Take a loan that can be easily repaid. Keep in mind that your car loan EMI should not exceed 15% of your net monthly income. Your personal loan EMI should not exceed 10% of your net monthly income. If your EMI is higher, you will not be able to save a dime for his retirement or to educate your child. Don’t accumulate a negative net worth.

Take loans for a short term:

Most financial institutions offer a maximum tenure of 30 years to pay the home loan. It may seem tempting to opt for it as you will be paying lower EMI. But, you don’t realise that the interest outgo is too high. If in 10 years you would be paying 57% interest on the borrowed amount, in 20 years it will shoot up to 128%. It is best that you take a short term loan that you can afford. But at times you have to take the longer term as you may not have enough income to pay off the loan in a short period of time. The best option here is to increase the EMI amount each year as your income increases.

Make the payments on time:

If it is your EMIs or a credit card bill, don’t miss the payment dates. Missing a payment will affect your credit score and hamper your chances of getting credit in the future. Prioritize your dues and never miss your credit card payment days as then you will be paying a hefty interest on the unpaid amount. If you don’t have enough money to pay the entire credit card bill, then pay the minimum and pay off the bill at the earliest. 

Don’t borrow to spend or invest:

Never use borrowed money for investment. The safe investments will not match the rate of interest you will be paying for your loan. The investments that offer higher returns are too volatile. Don’t take for discretionary spending like for travel etc. Don’t take a personal loan to buy an expensive watch or high-end bags. If you wish to go on a travel or buy an expensive shoe or a bag or a watch, start saving for it. 

Take insurance for big loans:

If you have taken a huge loan, then you might as well consider taking a term plan for the same amount to ensure that your family will not have to be burdened with the loan in the event you die due to unavoidable circumstances. Banks will offer a reducing cover plan but a regular term plan is better way to cover the liability.

Shop for better rates:

Keep your eyes open for changes in the interest rates and take into consideration the prepayment charges and penalty charges if any. Also look out for the switching charges. Compare the rates with various banks and then take a call on which financial institution that you must choose.

Read the fine print and understand it:

Loan documents are lengthy, but they are supposed to be read. Read the term and conditions so that you are not in for a surprise. Look for clauses and if there is anything that you do not understand, get it clarified.

Consolidate loans:

If you have too many loans running, consolidate as much as you can and replace them with cheaper loans, unsecured personal loan with charges up to 20% can be replaced with loan against life insurance policy. Loan against Property can be used to repay other outstanding loans. Prepay costly loans at the earliest, don’t keep them running to avoid tax. You are still incurring an expense even if it is saving you tax.

Don’t compromise on your retirement to avoid taking a loan:

You will not want to burden your child with education loan and hence compromise on building your retirement funds. Don’t risk your retirement just so you can educate your child. Make use of the various scholarships and loans.

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