Know about interest rate being charged on personal loan

Most of us take personal loans but do not pay attention on interest rates being charged. There are some points regarding the interest rates such as what is period the lender charging the interest for and how the interest is being calculated?

The first question for what period is the lender charging the interest? Whether the interest is being charged is 2% monthly, 2% half yearly or 2% yearly. An interest of 2%, is compounded monthly works out to a yearly rate of almost 27%.

Then how the interest is being calculated? For instance a bank is offering a personal loan of Rs 50,000 at an interest of 12% p.a which is to be repaid over a period of 36 months. Therefore the EMI to repay the loan works out to Rs 1,890 p.m. Here the question arises how a bank can offer a loan at an interest rate of 12% per year, when the interest rate of home loans is similar.

The bank’s calculated EMI in the following manner — an EMI of Rs 1,890 p.m. means that for 3 years you will have to pay the bank Rs 68,040 (Rs 1,890 x 36). Of this the principal amount i.e. the loan you have taken is Rs 50,000. What remains is the interest. So an interest of Rs 18,040 (Rs 68,040 - Rs 50,000) will be paid over a period of 3 years.

Therefore the interest paid per year totals to Rs 6,013 (Rs 18,040/3). Thus an interest of Rs 6,013 p.a. on a loan amount of Rs 50,000 means an interest rate of around 12%. This way of expressing interest is known as the flat rate of interest. But this is not the correct way to calculate.

The actual interest should be 21.25%, which is 9% higher than what the bank makes it out to be.

Thus every time an when you pay EMI a certain part of the principal amount i.e. the actual loan that you had taken is repaid. Therefore, the interest at any point of time has to be calculated on the outstanding loan.

Thus this is the correct way of calculating interest and is known as the reducing balance method.