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March 15, 2000
 Banking 
Understanding the interest rateLarissa Fernand When you are faced with a loan, the first issue to cross your mind would be the interest rate. However, just because two players are offering loan at an identical rate of interest, it does not necessarily mean that the cost of the loan is alike in both cases. On the other hand, if one is offering a slightly lower interest than the other, it need not indicate that the lower interest loan is a cheaper option. Welcome to the intricate world of interest rate calculations.
Annual, monthly or daily? Daily reducing basis means that the moment you make a payment, the very next day the interest is calculated on the balance principal. This will now be lowered since you have paid an amount. So, if you are being charged an interest on a principal of, say, Rs 10,000 and you repay Rs 3,000 today, the interest rate will change from tomorrow and be calculated on the balance Rs 7,000. Monthlyreducing basis means that principal amount you pay every month is deducted when calculating the interest rate for the following months. So, the interest rate will change only next month and be levied on the balance Rs 7,000. Annualreducing basis means that the total principal repaid by the end of the year is deducted when calculating the interest rate for the next year. Here, you continue paying interest on Rs 10,000 till the end of the year. Calculations on a dailyreducing balance are done mainly on credit cards whereby whenever a payment is made, the principal is immediately deducted. In the case of monthlyreducing balance, it takes place the next month and in the case of annualreducing basis, the next year. The thumb rule: the more frequently computed, the better. What's a 'flat rate' then? If a flat rate of interest is given, the effective rate works out to be much more. For example, assume you have taken a loan of Rs 1,20,000 and you repay Rs 40,000 every year. The interest calculation on an annualreducing basis will be on Rs 1,20,000 the first year, Rs 80,000 the next year and Rs 40,000 the third year. If it is the monthlyreducing loan, the amount of interest to be paid will drop the month after you make a payment. However, if it is a flat rate of interest, then you pay interest on Rs 1,20,000 every year. No principal deduction is taken into account. Let's put some figures to this. Assume you take a loan of Rs 85,000 for two years and the financier gives you a flat rate of interest of 9 per cent with an equated monthly installment (EMI) of Rs 4,179. On an annual reducing basis, this loan works out to 11.77 per cent and on a monthly reducing basis, 16.41 per cent. What about two identical rates?
Does it apply to a cheaper rate too?
Will the difference matter over long stretches of time?


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