Those lessons about interest rates need reworking
In most cases, customers taking out a loan or mortgage are likely to opt for the fixed/flat interest rate, which appears lower. Image Credit: Gulf News

Going for a bank loan? Be it a mortgage, personal loan or an auto financing, when you ask about the rate of interest, your personal banking advisor at the bank is likely to give two options – a flat rate and a reducing balance rate.

For most customers, it is a difficult choice between the two because they are simply not aware of the calculation methods and its implications on their equal monthly installments (EMI) and the total interest component over the loan period.

In all likelihood, customers will fall for the fixed/flat rate, which appears lower. However, the fact remains that under the flat rate, the equal monthly installments are likely to be higher and the total interest outgoing bigger depending on the rate charged by the bank.

Under normal circumstances, a reducing balance rate is equal to flat rate multiplied by 1.85. This calculation gives the borrower an approximate comparison between the two rates when applying for a loan. For example, if a bank offers a flat rate of 3 per cent on a loan, its equivalent in reducing balance is 5.55 per cent (3 x 1.85).

Which is better?

While the above simple formula gives us a basic comparison of the two types of rates offered, the relative merits of these two rates will depend on the total interest outgo during the loan period. Although the EMIs applicable in both cases may not tell the full story, the details of the EMI components will certainly tell which is more cost-effective for the borrower.

While the mechanics of EMI calculations are very important to compare both rates, very often most of us really don’t bother to know these while applying for a bank loan.

Factors influencing EMI

  1. Amount of loan taken
  2. Interest rate applied on the loan
  3. Type of rate (flat or reducing balance)
  4. Loan tenure

EMI is a normal form of monthly loan repayment consisting of interest and principal. It depends on four factors namely, the amount of loan taken, the interest rate applied on the loan, the type of rate (flat or reducing balance) and the loan tenure (period).

The concept of EMI allows a borrower to actually know well ahead of taking the loan how much he has to repay in monthly installments and the interest and principal components. Since monthly repayment consists of interest and principal, it also allows borrowers to know the progress of his loan repayment schedule throughout the loan period.

How flat interest rate works

Flat interest rate, as the term implies, means an interest rate that is calculated on the full amount of the loan throughout its tenure without considering that monthly EMIs gradually reduce the principal amount.

Where a flat rate is applied, the effective interest rate is noticeably higher than the nominal flat rate quoted in the beginning. As mentioned earlier, in terms of reducing balance rate, it works to about 1.85 times the flat rate quoted.

The formula of calculating fixed rate of interest is relatively simple and straight forward.

Interest Payable per Installment = (Original Loan Amount x Number of years x Interest Rate per annum) / Number of Installments.

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Where a flat rate is applied, the effective interest rate is noticeably higher than the nominal flat rate quoted in the beginning. Image Credit: Stock photo

For example, if a customer takes a loan of Dh100,000 with a flat rate of interest of 10 per cent per annum for 5 years, then you would pay annually Dh20,000 (principal repayment @ 100,000 / 5) + Dh10,000 (interest @10% of 100,000) = Dh30,000 every year. In monthly installments, it works to Dh2,500 per month.

Over the loan tenure, the customer would actually be paying a total of Dh150,000 (2,500 x 12 x 5) in principal plus interest. Therefore, in this example, the monthly EMI of Dh2,500 converts to an effective interest rate of 17.27 per cent per annum and a total interest payment of Dh50,000 over 5 years.

Banks in the UAE offer fixed rates on almost all types of loan products ranging from personal loans and vehicle loans, overdrafts and cash against credit cards. In this method of interest calculation, the customer would have to pay interest on the entire loan amount throughout the loan tenure. It is actually less popular among the borrowers because even if you gradually pay down the loan, the interest component does not decrease.

Reducing balance rates

Reducing balance rate, as the term suggests, means the interest rate is calculated every month on the outstanding loan amount. In this method, the EMI includes interest payable for the outstanding loan amount for the month in addition to the principal repayment. After every EMI payment, the outstanding loan amount gets reduced. Therefore, the interest for the next month is calculated only on the outstanding loan amount.

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All UAE banks give customers the options to choose between flat rate and reducing balance rates on most loan products. Image Credit: Stock photo

All UAE banks give customers the options to choose between flat rate and reducing balance rates on most loan products. Personal banking advisors usually calculate and give the borrowers the reducing balance based schedule of EMIs for the entire loan period. While bank staff use the loan calculators on their computer systems, some banks have loan calculator programmes or links to such programmes on their websites.

A simple search on internet also brings up a number of loan calculators that give all details such as EMIs based on reducing balance and the total effective interest rate payable over the loan period, based on the loan amount and the applied interest rate. Here are a few popular loan calculators.

There are dozens of these loan calculators available online. In addition to detailed break up of loan payment schedule, monthly and yearly interest and principal payments, some of these calculators also help you to find your loan eligibility based on your income, prevailing debt burden ratio, credit score and loan to value ratios for mortgages.

Want to try manual calculations?

Much before computer programmes solved all our problems, we used to do all sorts of calculations manually. Although a number of spreadsheet-based software programmes and simple online calculators are giving us solutions within a few seconds, there are manual calculating methods that can be used as well.

The mathematical formula for calculating monthly installments under reducing balance payment is:

EMI = [P x R x (1+R)N]/[(1+R)N-1], where P stands for the loan amount or principal, R is the interest rate per month [if the interest rate per annum is 3.5 per cent, then the rate of interest will be 3.5/(12 x 100)], and N is the number of monthly installments.

Let us try this formula with an example. Assume a borrower takes out a personal loan of Dh500,000, which is the principal loan amount, at an interest rate of 3.5 per cent for 10 years.

The EMI is calculated ((500,000 x (0.035)) x (1 + (0.035 / 12))120;) / (12 x (1 + (0.035/12))120; - 1). In this case, the EMI would be Dh4,944.

In reducing balance method of calculating interest rates, although the EMI, as the name denotes will remain a constant, the interest component of the loan will come down with each installment of the loan repayment.

There are a number of loan calculators that give all details such as EMIs based on reducing balance and the total effective interest rate payable over the loan period. Image Credit: Stock photo

Which type of interest rate is better?

There is no clear cut answer to the above question. It is subject to comparable rates in both these options that ultimately translate into the effective interest rates one pays to the bank. Flat interest rates generally range from 1.7 to 1.9 times more, when converted into the Effective Interest Rate (or reducing balance) equivalent. Customers should make this choice based on this comparison. Bankers say if the reducing balance rate offered is anything higher than 18.5 times the flat rate offered, flat rate is a better option and vice versa.

Key difference between flat rate and reducing balance rate

  • In flat rate method, the interest rate is calculated on the principal amount of the loan. On the other hand, interest rate is calculated only on the outstanding loan amount on a monthly basis in the reducing balance rate method.
  • Flat interest rates are generally lower than the reducing balance rate.
  • Calculating flat interest rate is easier as compared to reducing balance rate in which the calculations are quite tricky.
  • In practical terms, the reducing rate method is better than the flat rate method.