Fixed Vs Reducing Balance Loan EMIs-Which is best for you?

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Recently one of my client searching for gold loan for his financial need found that one NBFC (Non Banking Financial Companies) offering a better interest rate than banks. In first instance he felt happy that he is getting lesser interest rate than even nationalized banks.

But he shocked when EMI was told to him. Reason was, that NBFC calculated EMI based on fixed interest rate rather than reducing balance method. Hence whenever you go for loan dont concentrate only on interest rate which they offer, instead you need to concentrate on the method of EMI or interest calculation method too.

Usually their are two types of interest calculation methods. One is called Fixed or Simple interest calculation method and another is Reducing Balance method. Let us see with one example which will give more clarity. Suppose you are going for gold loan worth Rs. 25,00,000 tenure will be 1 year and rate of interest 12%.

1) Fixed or Simple Interest calculation method-Now in this method they calculate interest on the principal amount Rs.25,00,000 for the whole tenure of loan which will be Rs.3,00,000 in this case. They add this interest with principal which will be Rs.28,00,000 and divide this amount into 12 equal parts to arrive at your monthly EMI which will be Rs.2,33,333. So in this case you pay Rs.3,00,000 as a total interest for this loan.

2) Reducing Balance Method– In this method also we consider the same values for our calculation. In this method of calculation your EMI will come out to be Rs.2,22,121. In this type of calculation method, every month whatever you pay as EMI, in that principal part is get reduced and on the rest of the amount interest will be calculated and charged you for that month. Hence principal will not be constant in this method, it gradually decreases monthly and at the end of 12th month your principal will be zero. Usually during the start of loan major part will go towards interest and minor part will be towards principal.

From the above two methods with data being same, we noticed that we paid total Rs.1,34,537 high interest than reducing balance method. Hence always dont look at the interest rate part only instead concentrate on the interest calculation method too. Usually such type of fixed or simple interest calculation method loans will offer you lesser interest rates than reducing balance method loans. But ask the difference of interest payment you need to pay then go for the suitable loans.

 

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18 Responses

  1. Dear Sir,

    I am Applying Bike Loan of amount 1,47,838 . And Loan Taken for 3 Years with Flat rate is 10.5% interest and Reducing rate is 18% interest
    Please guide which is preferable for me.

  2. Sir
    I m planing for car loan for 5 yrs
    Ford is giving me 6.99 flat interest rate and icici bank is giving 10.25 reducing interest rate so which is going to be good ford company flat rate or reducing interest

  3. Sir,
    I am takeing a heavy veichle for transport buissenes the loan is of 1450000 rupees for 4 years what should i choose the private finance company whoes rate of flat intrest is of 5.70%/year or bank reducing loan case at 11.50% rate of intrest.

  4. Sir mera nam manoj hai. main 6 lakh ka loan lene ka plan kr rha hun. Sbi se 5 years k liye. Rate of interest 12 % Lekin EMI flat lun ya reducing. Isme confuse hun. Lekin interest kam aaye. Sir plz guid me soon….

  5. Dear Sir,

    I am Applying Home Loan as amount 17.5 Lac. So please give me example or emi calculate Monthly Details.
    And Loan Taken for 20 Years.

    Also guide which was the prefable for me.

    And which other details check before take a loan…

  6. Sir, i did post graduate diploma in portfolio management. Hence kindly guide me how to b certified financial planner like and from where that degree can be obtained?

  7. Dear Basu,

    Thanks for this clarity in different types of interest calculations.

    I would like to know in case of reducing balance method, how do the calculation made and arrive at a certain EMI? Also what is the calculation for interest and principal proportion during initial days and throughout the loan tenure?

    Please guide.

    Regards,
    Saravanan

    1. Saravanan-Calculation will be exactly like CAGR (compounding). But in the initial stage of your EMI, interest will eat more and as the time passes principal will be at higher but interest part will get reduced as year on year principal get reduced.

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