Know your interest rate

  • Sajad Bazaz
  • Publish Date: Jul 29 2019 3:51AM
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  • Updated Date: Jul 29 2019 3:51AM
Know your interest rateRepresentational Pic

In money matters one of the most important components is the rate of interest. It cannot be overlooked. When you invest your money in any savings or investment scheme, it’s this rate of interest which decides the amount of return on your savings or investment. When you take route of any loan scheme to borrow money from banks or financial institutions, it’s again the rate of interest which is used to fix cost of your loan. 

So, it makes a sense for you to give attention to rate of interest while dealing with a bank or a financial institution, especially when you are borrowing money.

Let me apprise you about the strategy behind fixing rate of interest on financial products extended to you as a platform to borrow money for different needs. Why I am focusing on loan schemes? The reason is simple. I am sure you will agree that in the contemporary times, our lives are almost entirely banking upon loans. Borrowing money from banks and financial institutions has become an inevitable component of our domestic budgets. Precisely, we cannot progress without the support of a bank loan.

Usually there are two options to charge interest on loans -fixed rate and floating rate option. In fixed rate option,  interest rate is fixed for the entire period of the loan. However, this fixed rate option too can change. Nowadays, banks include a reset clause in the loan agreement in which the borrower authorizes the bank to reset the fixed rate whenever deemed fit by the bank. Mostly, the borrowers are unaware of this reset clause of the fixed rate option. When the bank invokes this clause at any point of time during the currency of the loan, the borrowers call it cheating by the bank, which actually it is not. We have seen most of the borrowers have a habit not to go through the loan agreement documents before availing the facility. They only come to know about terms and conditions when the banks enforce them.

In case of floating rate loan, obviously the interest rate is not fixed. It is linked to the Marginal Cost of funds based Lending rate (MCLR). This lending rate refers to the minimum interest rate of a bank below which it cannot lend, except in some cases allowed by the RBI. It is an internal benchmark or reference rate for the bank.

If the MCLR goes up, interest rate on the loan also goes up and subsequently equated monthly installment (EMI) will also go up. However, if the MCLR goes down, the interest rate and monthly repayment on the loan will also go down. The bank fixes a spread between MCLR and floating rate while sanctioning a loan. The spread remains constant during the tenure of the loan. 

As a borrower, you have to keep it in mind that any loan has two components: principal and interest. Principal is the amount borrowed from a financial institution, and interest is the money paid back over and above the principal amount. Generally, loans are structured in such a way that during the initial repayment period, the borrower pays more towards interest and less towards principal. The EMI paid over a period of time gradually reduces the principal amount.

Now most important thing to understand is the methodology of applying interest on your loan amount. Two common methods are used for calculating interest on loans – flat interest rate method and reducing balance interest rate method.  

Flat rate method is the percentage of interest charged on the initial loan amount (principal amount) each and every year during the currency of the loan. The interest would be charged on the initial loan amount and here amount repaid in equated monthly installments is not counted. Precisely, you have to pay interest on the entire loan amount (principal) throughout the loan tenure.   

A flat interest rate does not factor in the gradual reduction in the principal amount. For instance, if your bank is offering you a flat interest rate of 7%, and you borrow Rs.5 lakh for a period of five years, the total EMI will be approximately Rs.11,380. In this case, the effective interest rate will be approximately 13% per annum.

So, flat interest rates being generally lower than the reducing balance rate, are actually the rates ranging from 1.7 to 1.9 times more when converted into the effective interest rate equivalent.

As far as reducing balance interest rate method is concerned, it doesn’t conceal any further percentage of interest. Under this method, interest is calculated every month on the outstanding loan amount. In this method, the equated monthly installment includes interest payable for the outstanding loan amount for the month in addition to the principal repayment. The interest for the next month is calculated only on the reduced balance or outstanding loan amount.

Meanwhile, it is true that there are a few question marks as far as transparency in the calculation of floating interest rates is concerned. But at the same time, it is also a fact that customers are always in a hurry while taking a loan. They focus more on sanctioning and disbursement of the loan rather than to have a look at the terms and conditions at which they are taking the loan. Most of the time, they even sign legal documents without going into the details of the content in such documents. 

In our state (J&K), where we have customers who cannot calculate difference between a fixed rate option and a floating rate option, there is urgent need for a financial services clinics. People here need advice on various financial matters so that they are able to take most of the benefits out of the financial system and strike a better deal. The time also demands that banks act as financial advisors to its customers in any financial transaction conducted at their branches so that a floating rate loan beneficiary is not taken by surprise when his EMI is raised midway of his repayment schedule.

In succinct, while availing a loan, always understand the interest rate carefully. If you are being offered a rate below the minimum rate, it is a red flag.