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.
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).