Financial institutions have various parameters surrounding the loan amount detailing the manner in which the loan is repaid. One such parameter is 'rest'.
This is the regular interval at which the loan amount balance is recalculated and also refers to the periodicity of compounding. This can be possible only in the case of reducing balance loan amounts. A rest can be yearly, monthly or even daily.
Choosing your loan offer
Gayatri approached a bank and chose a loan that offered an annualised rate of 12.75 per cent for a loan amount of Rs 20 lakh for 20 years, while her sister Sanjana had shortlisted among several loans, one that offered an annualised interest rate of 13 per cent. Who got the better bargain?
The loan offer Gayatri obtained was a flat rate loan. Banks can calculate their interest rates either at a flat rate or a reducing balance rate. Sanjana on the other hand, had shortlisted two reducing balance loan offers with different rest periods. As her calculations revealed the loan offer with a monthly rest turned out to be a better loan bargain than the one with an annual rest. Let us examine these two aspects stated above in detail.
At a flat rate, the interest rates are calculated keeping the outstanding amount (i.e. the amount on which interest is calculated) constant throughout the loan tenure while in a reducing balance loan the interest rate is recalculated on a periodic basis based on the reducing outstanding loan amount.
At any given point, a flat rate is always more expensive than an annual reducing balance rate. Even in the case of a reducing balance loan, a significant factor that impacts the loan cost is the time interval at which the reducing balance is recalculated, which could be monthly, daily, yearly, quarterly or half yearly. The accompanying table illustrates the two cases.
It is clear that the effective interest that Gayatri will need to pay amounts to Rs 51 lakh while the loan offers Sanjana had zeroed in has a difference of nearly Rs 20 lakh in the interest paid.
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 was quick to realise this and her calculations revealed that an annual rest would mean that even when you pay EMIs, the loan amount will be recalculated only at the end of the year. This means you would continue to pay interest on the entire loan amount till that particular year (compounding period, when the outstanding loan amount is recalculated) ends, even when the outstanding loan amount reduces each month.
In the case of a monthly rest, the balance amount is recalculated every month. Hence it is to the advantage of Sanjana to take up a loan offer with the rest that more closely matches the frequency of repayment. So if you are repaying on a monthly basis, take up the loan offer that gives you the best rate on a monthly rest.
Banks generally quote an "annualised" interest rate, but remember that interest rates can be deceptive unless you figure out how they are defined. You can easily calculate the total interest by multiplying your EMI into the number of monthly instalments and subtracting the loan amount from this figure. You can then easily identify which loan is most cost effective. Remember to account for any upfront fees while comparing two loans.
What about daily reducing balance, you may wonder. It makes sense to opt for it only if you receive your income at different points during a month and can repay your loan at several or different points of time during a month.
While this may not make sense for a salaried individual, it becomes very relevant to self-employed people that will have funds coming at irregular intervals.
In sum, the key to understanding your loan offers is to zero in the one that gives you the least total interest outflow.
— ABITHA DEEPAK is Head-content & research, Bankbazaar.com