How Banks Calculating the Diminishing Balance Interest Rate on Loans

 

 

 

This article gives an exact idea on the methods that banks are using to calculate the diminishing balance interest of any outstanding loan.

With a repayment schedule receiving from the bank, customer can manage the loan balance repayment in an effective way if have good knowledge on how they calculate the diminishing interest balance.

 

 

When customer started to repay the Equated Monthly Installment (EMI) amount on a loan, even after paying for several initial months, he or she may not see any or very less reduction in the loan amount.

It is difficult to reduce the loan amount even after paying the EMI for the initial months because, huge part of the initial month EMI’s directly going to the interest part of the loan instead of the principal amount.

 

Upon continuing the repayment through EMI religiously, the amount going to the loan interest part will gradually reduce and more money will start going to the principal amount.

If have a plan to apply for a loan, one must know all about the loan repayment schedule. Loan repayment payment schedule would give an exact idea on the percentage of EMI amount to interest part and principal part in each month.

 

 

Banks using the method of multiplying the remaining loan amount at the beginning of each month with the interest rate and then dividing by 12. This would give the result with the EMI amount part to interest and to principal. This activity continues until completely repaying the loan amount.

 

To understand the interest rates that banks are taking from a loan holder in any particular month, Identify the interest amount for that month using the above mentioned method and divide by 12. This will be applicable to understand the diminishing rate.

A diminishing rate means, the calculation of interest applicable only to the remaining loan amount.

 

 

As a bonus, I would like to inform another interest rate called flat rate. Comparing with diminishing interest rate, flat interest rate requires the customer to pay the interest on the whole loan amount (principal) during the whole tenure of the loan.

This is applicable even the loan principal reduced to minimum level.

 

Example:Suppose you have taken a loan of $1 Lakh at 15% flat interest rate for 1 year (You can use the local currency to calculate this). Loan repayment EMI that you are paying back consists of interest and principal parts. Through paying EMIs, the principal starts reducing.

However, even though the principal is reducing, you are still required to pay the interest for the whole loan amount, that is $1 Lakh). For your information, flat rate commonly known as a ‘predetermined’ credit charge.

Example for Flat Rate Interest Calculation:

 

 

Interest charged on the full amount of a loan throughout its entire term and commonly known as a ‘predetermined’ credit charge.

 

The flat rate takes no account of the fact that periodic repayments, which include both interest and principal, gradually reduce the amount owed.

 

Consequently, the effective interest rate is considerably higher than the nominal flat rate initially quoted.

 

All lenders must state the effective rate to borrowers; contracts based on flat rates of interest, already uncommon by the mid-1990’s, were prohibited under the uniform credit Code legislation.

 

Anyone confronted with a flat rate of interest should remember: a rough rule is that 9 per cent flat equates to about 17 per cent effective per annum, i.e, double the flat rate less one per cent, although this varies with the term of the loan.