Sanjeev Joshi, a manager in an FMCG company, wanted to refurnish his house. Being short of funds, he decided to approach a bank for a personal loan.
The bank offered him Rs 300,000 at a flat rate of 15 per cent for three years. He was rather surprised as he had been told that interest rates were on the rise and that he would have to pay at least 18 per cent interest or more for a personal loan. He patted his back for being lucky.
Imagine his surprise when he was told by his chartered accountant that his interest rate was much more than the promised 15 per cent. That is, he was going to pay a total amount of Rs 435,000 at the end of three years.
This amount would have been perfectly fine, if he had paid this entire amount in one go after three years. But here he was paying an equated monthly instalment Rs 12, 083. In other words, his principle as well as interest should be coming down every month, yet he had to pay the same amount for three years.
Says Sajag Sanghavi, certified financial planner, "We advise our clients not to take loans on flat rates as it is the most expensive rate that the bank offers."
According to him, in a rising rate regime, personal loans are the most expensive and one should take them, in case of an emergency.
So what are the option? Says Mukhesh Dedhia, director, Ghalla and Bhansali, "One should always ask for the reducing balance rate when offered a flat rate of interest." Under the reducing balance method the principle gets reduced daily, monthly, quarterly or yearly.
Also, as the principle amount gets reduced, the interest that you pay is on the reduced principle and therefore lower, as well. Obviously, the more often the balance is reduced, it is better for the consumer.
Let us take Sanjeev's example to work out the numbers. He has borrowed Rs 300,000 for 3 years at 15 per cent per annum. The EMI is Rs 12,083. But if one were to use the monthly reducing balance method, the interest rate would be almost 26 per cent per annum.
Also, if he were to pay using the monthly reducing balance method, his EMI would work out to Rs 10,400. So in effect, he is paying Rs 1,683 more every month. That works out to Rs 20, 196 per year.
As we can clearly see from the above example, there is almost a 10-12 per cent difference between reducing balance and flat rates. Ultimately, that has a huge impact on the cost of the loan.