How the interest rates are calculated in banks? Broadly speaking there are two types of Interest rates available in the banking sector.

1. Flat Interest rate

2. Diminishing Interest rate

__Flat Interest rate__:

An interest charge on the full amount of a loan throughout its entire term is known as Flat Interest rate.

For Example:

Take the following case

**Loan amount**: Rs.100000 **Flat Int Rate**: 10% **EMI**: Rs.2500 **Interest monthly outgo**: 833.33 **Principal Monthly outgo**: 1666.67 **Interest yearly out go**: 10000 **Principal Yearly out go**: 20000

Following table depicts the interest out go and the Rate of Interest actually they charge.

Year | Opening principal | Interest outgo | Principal outgo | Closing principal | Rate of Interest (in %) |

Ist year | 100000 | 10000 | 20000 | 80000 | 10 |

IInd year | 80000 | 10000 | 20000 | 60000 | 12.5 |

IIIrd year | 60000 | 10000 | 20000 | 40000 | 16.67 |

IVth year | 40000 | 10000 | 20000 | 20000 | 25 |

Vth year | 20000 | 10000 | 20000 | Nil | 50 |

Total | | 50000 | 100000 | | 114.17% |

So the actual amount we end up paying would be Rs.**150000**. So the actual interest rate charged is 22.83% (114.17/5)

__Diminishing Rate of Interest__:

Under Diminishing rate of interest the repayment is deducted (say every month) from the loan and the interest is charged only on the balance principal.

For Example: if instead of 10% p.a. flat rate (in the above example), interest is charged at 10% p.a. Diminishing balance rate, EMI amount would be Rs 2,124.70. You would pay Rs 833.33 as interest in the first month and Rs 1,291.37 (2,124.70 – 833.33) would be Principal Repayment. For next month interest will be charged only on reduced principal, i.e. 100,000 less 1,291.37 = 98,708.63. Interest for second month would be Rs 822.57 (98,708.63 * 10% / 12) and principal repayment would be Rs 1,302.13 (2,124.70 – 822.57). Thus over the tenure of the loan, you would end up paying Rs** 127,482 **(2,124.70 * 12 * 5).

Labels: Finance