Unveiling Strategies Banks Use to Manipulate Loan, Credit, and FD Interest Rates: A Look at 5 Deceptive Tactics
In the world of home loans, understanding the difference between simple interest and reducing-balance interest rates can significantly impact your financial future.
Simple interest, also known as a flat interest rate, calculates interest on the original principal amount for the entire loan tenure, regardless of repayments made. This means the interest amount remains constant throughout the loan period, potentially resulting in a higher total interest cost. For example, if you borrow ₹1,00,000 at a 10% flat rate for 3 years, the interest is always calculated on ₹1,00,000.
On the other hand, reducing-balance interest rates are more common in home loans. Here, interest is calculated on the outstanding loan balance after each repayment. Because each payment reduces the principal, the interest amount decreases over time, making the loan more affordable overall. For the same ₹1,00,000 at 10% reducing rate, the interest paid will be less than under a flat rate since it’s recalculated on the lower outstanding balance each period.
The key differences are summarised in the table below:
| Aspect | Simple Interest (Flat Rate) | Reducing-Balance Interest Rate | |--------------------|-------------------------------------------------|-------------------------------------------------------------| | Interest Calculation| On full original principal | On outstanding principal balance after each payment | | Total Interest | Generally higher total interest | Lower total interest owing to declining principal | | EMI Calculation | Easier to calculate, monthly payment is fixed | More complex calculation; EMI includes reducing interest | | Affordability | Costlier | More affordable due to decreasing interest payments | | Common Usage | Rare in home loans; more in personal loans | Common method used for home loans |
Moreover, in reducing-balance loans, interest is often calculated daily or monthly on the current balance, making early repayments more beneficial by lowering subsequent interest.
Prepaying a home loan, especially during the initial years, can result in significant interest savings. For instance, prepaying Rs 2 lakh every year can reduce a 20-year loan tenure to 11 years and save over Rs 27 lakh in interest.
It's crucial to note that banks and NBFCs must ensure that an increase in loan tenure does not result in negative amortization, so borrowers will not face a 100-year loan scenario. In an increasing interest rate scenario, avoiding lower EMIs can prevent negative amortization, where the remaining interest starts to add to the principal, causing the outstanding principal to increase and attract more interest.
Borrowers now have the flexibility to opt for enhancement in EMI or elongation of tenor or a combination of both, and to prepay, either in part or in full, at any point during the loan tenor. However, increasing your EMIs may stretch your finances, and it's important to consider this before making a decision.
When taking a loan, it's important to know which interest rate the banker is referring to. Salespeople may attempt to mislead borrowers by promoting low interest rates based on simple interest, while the actual rate could be significantly higher when calculated using the Reducing Balance Method.
In summary, understanding the Reducing Balance Method is crucial when evaluating home loan interest rates. It's not enough to pay only the minimum dues on a credit card; paying the full outstanding dues at the end of the settlement period is crucial to avoid falling into a debt trap. When evaluating FD interest rates, it's important to understand different metrics, such as the actual interest rate, annualised yield, and effective annualised yield, to make informed decisions about investments.
In the realm of personal finance, considering investments beyond home loans is beneficial for future financial stability. For instance, fixed deposits offer a fixed return on investment for a specified tenure.
Mutual funds, another investing avenue, allow diversification of investment portfolio by pooling money from multiple investors to buy shares, debentures, and securities.
To aid in making informed decisions about personal and home loans, an EMIs calculator is a useful tool that helps estimate monthly repayments based on the loan amount, interest rate, and tenor.
