Interest Rates, Explained
George wants to travel to Europe next month. Unfortunately, he does not have the money to do so. So he decides to take a personal loan of Rs. 3 Lakhs.
As soon as he shows interest, he is contacted by two lending companies, LendEasy and LendMart.
LendEasy offers him a loan of Rs. 3 lakhs at an interest rate of 9% for 3 years.
LendMart offers him a loan of Rs. 3 lakhs at an interest rate of 10% for 3 years.
Which one do you think George should pick?
The LendEasy offer, right?
Not so fast.
What they didn't mention was how they are calculating the interest rate. Interest Rate can be calculated in two ways:
Let us help you understand the difference between the two.
As you all know, we usually pay back a loan in EMIs.
Each EMI you pay has two components, principal, and interest.
Let's take the LendEasy offer,
Assuming it's a flat interest rate, the EMI would come to:
As you pay back each EMI, the principal part gets knocked off of your loan amount. So each time you pay an EMI, your outstanding amount reduces.
Here is where it becomes interesting. In flat interest rate, the interest is calculated on the Loan Amount while in the case of reducing interest rate, the interest is calculated on the outstanding amount.
So if you have taken a loan with reducing interest rate, the interest component comes down each month because your outstanding reduces each time you pay an EMI.
Let's go back and help George.
Assume the LendEasy offer has a flat interest rate and the LendMart offer has a reducing interest rate.
Comparing the two:
So George would have ended up paying close to Rs.41,500 extra if he had taken the LendEasy offer, even though the interest rate seemed lower.
What can you learn from this? Anytime someone tries to sell you a loan, ask if the interest rate is reducing or flat and see if you can afford to pay it back.
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