# Fixed and reducing balance interest rate in personal loans!

By | September 18, 2012

Despite the widespread usage of personal loans by most people to raise capital in a short time, there is still a great degree of confusion regarding the interest rates that are applicable on these loans. Most burrowers are not sure about the method of calculation on interest and the amount that has to be paid. This usually results in many customers ending up in paying higher amounts while repaying despite having chosen a loan that promised lower interest rates. While the natural tendency of any burrower would be opt for a loan that claims a lower interest rate, the actual implications are not fully appreciated resulting in payment of a much higher amount than a similar loan with slightly higher interest rate.

How is Interest Calculated

This is the most difficult part where most people miss out on the essentials. There are two basic types of calculations for interest rates.

Fixed Interest Rate: This simple method is the most preferred means as majority of the burrowers can appreciate the workings. In this method the interest rate is fixed at the time of the loan approval and calculated for the loan amount for the entire duration of the loan tenure. The interest amount along with the capital amount is then distributed into equated monthly installments spread over the repayment period.

For example: If the loan amount is Rs. 200000 for tenure of 3 years with a 10% interest rate, the customer has to pay back interest of Rs. 20000 for 3 years which amounts to Rs. 60000 which is added to loan amount Rs. 200000 and the total amount of Rs. 260000 is divided equally into 36 installments of Rs. 7222 each.

The problem in this method of calculation is that the amount of principal paid back is not deducted from the loan amount over the 3 years.

Reducing balance Interest Rate: In this method of calculation whatever installment is paid, its principal element is deducted from the loan amount and the new interest is calculated on the remaining portion of the loan principal. Thus interest is applicable for only the outstanding portion of the loan amount as on that day. Since there is a gradual reduction in the base amount the amount towards interest also reduces as the repayment progresses. At the end of the loan paying tenure the total amount paid in this manner will certainly be lesser than that paid in a fixed interest personal loan. However, currently all the reducing balance loans available in the market have a higher rate of interest as compared to the fixed interest loans. But despite the higher rate this method of calculation will still work out to be cheaper in the long run for most of the personal loans.

The customer has to carry out this calculation and see for himself the total amount repaid in both the means of calculation prior to finalization of the loan type. Therefore in many instances of personal loans the lower fixed interest rate may actually be costlier than the higher reducing balance interest type of loans.

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