This article is to provide you an idea on how banks calculating
the monthly diminishing interest for an outstanding loan amount. With the
repayment schedule from bank and on your loan, you can manage the loan balance
re-payment in an effective way if you have good knowledge on how this calculation is happening.
Here you go.
Once you have the details of Equated Monthly Installment (EMI) amount to repay the loan and after making payment for several months, you may not see any changes in the loan amount. It is difficult to reduce the loan amount even after paying the EMI in right time for the initial months because; huge part of the EMI’s directly going to the interest part of the loan instead of the principal amount.
When the repayment through EMI continuing, the amount going to the loan interest will gradually reduce and more money would go to the principal of the loan.Those who are planning for applying a loan should ask and confirm the loan repayment schedule to understand such changes. Loan payment schedule should have the information on how the amount getting distributed between principal and interest parts of the loan.
Once you have the details of Equated Monthly Installment (EMI) amount to repay the loan and after making payment for several months, you may not see any changes in the loan amount. It is difficult to reduce the loan amount even after paying the EMI in right time for the initial months because; huge part of the EMI’s directly going to the interest part of the loan instead of the principal amount.
When the repayment through EMI continuing, the amount going to the loan interest will gradually reduce and more money would go to the principal of the loan.Those who are planning for applying a loan should ask and confirm the loan repayment schedule to understand such changes. Loan payment schedule should have the information on how the amount getting distributed between principal and interest parts of the loan.
Diminishing Interest Calculation
To get the amount that going to the interest part in each months, banks using the method of diminishing interest calculation formula by multiplying the remaining loan amount at the beginning of each month with the interest rate and then dividing by 12.
To understand the interest rate that bank taking from a loan holder in any particular month, Identify the interest amount for that month using the above mentioned method and again divide this by 12. This will be applicable to understand the diminishing rate. A diminishing rate mean, the calculation of interest applicable only to the remaining loan amount after paying the EMI each time.
Example:
Loan
Amount
Rs 100000/-
Tenure
5 Years
Rate of
Interest 10% p.a.
Calculation
EMI
Amount
= Rs. 2125/-
Total Amount paid
= Rs. 127500/-
Interest
Amount
= Rs. 27500/-
Flat Rate Interest Calculation
Like diminishing interest rate, flat rate interest also popular in the loan space. Compare with diminishing interest rate, when you take a flat rate loan, you required to pay interest on the whole amount (principal) during the whole tenure of the loan even when the principal is gradually reducing during the term of the loan. Suppose you take a loan of Rs.1 Lakh at 15% flat rate of interest for 1 year. The EMI that you pay consists of both interest and a part of the principal. So, as you pay the EMIs, the principal goes on reducing. However, even as the principal is reducing, you are still paying the interest on the whole amount, that is Rs.1 Lakh). For your information, flat rate commonly known as a ‘pre-determined’ credit charge.
Here’s a very simple example
on Flat Rate Interest:
Example
Loan
Amount
Rs 100000/-
Tenure
5 Years
Rate of
Interest 10% p.a.
Calculation
Interest
Amount
= Rs. 50000/-
(100000 x 10% x 5)
EMI
Amount
= Rs. 2500/- per month
for 5 years
(Rs. 150000 / 60 months)
Key Points to Remember When Calculating Interest: Flat Rate vs. Diminishing Rate
Understanding how interest is calculated is crucial for any borrower or investor. Here's a breakdown of the key points to remember when comparing flat rate and diminishing rate interest:
Flat Rate Interest:
- Interest on Total Principal: The interest is calculated on the entire loan amount borrowed at the beginning of the loan term.
- Fixed Monthly Payment: The monthly payment remains constant throughout the loan term, consisting of a portion of principal repayment and a fixed amount of interest.
- Higher Total Interest Paid: Since interest is calculated on the full amount throughout, you end up paying more total interest over the loan term compared to diminishing rate.
- Simpler Calculation: Flat rate interest is easier to calculate as it's a fixed percentage applied to the initial loan amount.
Diminishing Rate:
- Interest on Outstanding Balance: Interest is calculated only on the remaining loan balance after each payment. As you repay the principal, the outstanding balance decreases, and so does the interest amount charged.
- Decreasing Monthly Payment (Optional): The monthly payment can decrease slightly over time as the interest portion shrinks with the reducing balance. However, some lenders might maintain a fixed payment structure.
- Lower Total Interest Paid: Due to the decreasing balance, you pay less total interest over the loan term compared to a flat rate loan with the same interest rate and loan amount.
- More Complex Calculation: Calculating diminishing interest requires considering the remaining balance after each payment, making it slightly more complex.
Choosing the Right Method to Calculate Interests:
The type of interest calculation used depends on the loan product and lender. Flat rate might be applied to short-term loans, while diminishing rate is common for mortgages and personal loans.
Remember:
- Always ask the lender or read the loan agreement carefully to understand how interest is calculated.
- Consider the total interest paid over the loan term when comparing loan options.
