Home Loan Interest rate calculation
In the previous article we discussed about the EMI (equated monthly installment) component (Principal + Interest). We discovered that in the initial years, the interest component of the annual repayment for the loan could be as high as 80% of the payment.
In this article we would like to highlight the way housing finance companies (HFCs) charge interest to arrive at the value of EMI that you are supposed to pay. This will help us find out how the different methods of interest calculation change the value of your EMI.
The way housing finance companies (HFCs) charge interest to arrive at the value EMI can be broadly classified into ‘Flat rate system' and ‘Reducing balance rate system'. In the flat rate system, the rate of interest on the loan amount is calculated over the entire duration of the loan and the principal plus the interest is divided over the number of installments and the value arrived is your EMI. But in case of 'Reducing Balance' system, the interest is charged on the outstanding balance of the loan, which goes on reducing.
The reducing balance can be further classified into monthly reducing, quarterly reducing and annual reducing methods based on the number of times the principal is reduced/credited in a year. Suppose the principal is reduced 12 times a year, it is termed as monthly reducing balance method, if the principal is reduced 4 time a year, it termed as quarterly reducing balance method and if the principal is reduced 1 time a year, it known as annual reducing balance method. Annual reducing balance method is very common with Indian HFCs and monthly reducing balance method is popular among the foreign banks and nationalized banks, engaged in the activity of housing finance.
Lets find out the effect of the different methods of EMI calculation
Loan amount: Rs 1,000,000
Interest: 12.25% (monthly reducing)
Interest: 12.25% (annual reducing)
calculation || Annual reducing ||Monthly reducing || Difference |
| Loan Amount (Rs) || 1,000,000 ||1,000,000 || - |
|Interest rate (%) ||12.25 ||12.25 ||- |
|EMI (Rs) ||12,400 ||12,163 ||237 |
|Years ||15 ||15 ||- |
The table above clearly shows that EMI pay out for the same loan amount, interest and years, is much lower in case of monthly reducing balance method as compared to annual reducing balance method. This is because in the case of monthly reducing balance method you are required to pay interest on the principal, which is reduced every month. But in case of annual reducing balance method, the principal is reduced once in a year, that too at the end of the year. As a borrower you are definitely benefited going with HFCs that charge interest on a monthly reducing balance.
Another generic classification of EMI calculation and the interest rate charged, followed by HFCs and banks are, fixed or floating rate of interest. In the recent past, floating rate scheme for housing loan has become popular. Under this scheme, the rate charged varies with a benchmark, which is the generally prime lending-rate (PLR). But in case of fixed interest rate home loan scheme, the interest rate charged by HFCs remains fixed or same throughout the term of the loan. Most of the nationalized banks and foreign banks prefer to offer floating rate of interest on housing loan.
HDFC, the market leader in the domestic housing finance industry was the first HFC to offer floating rate home loan scheme in the form of Adjustable Prime Lending Rate (APLR). The most recent housing finance companies to offer floating rate housing loan scheme is ICICI home loan. ICICI home loan has stirred up competition in the housing finance industry by launching floating rate scheme at 11.5%, that too on monthly reducing balance method. The current rate offered by ICICI home loan is by far the lowest in the industry.
So, while applying for a home loan always keep in mind these classifications and make sure you inquire into the mode of interest calculation, or to make it simpler check the EMI value per Rs 100,000. Needless to say, lower the EMI, the better for you.
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