The interest rate rip-off

19 October 2005

Taking that tempting on-demand low-interest loan or some seductive 'zero-interest' vehicle finance can cost you more than you think, says Sanjay Matai. A primer to understand interest rates and calculate the true cost of your loan

Till a few years back, it was virtually impossible for individuals to avail of loans, whether for a car, a house or any other personal loans. That is now history. Today, you can get a loan sitting in the comfort of your house. They are just a phone call away. And the best part is that the interest rates have dropped sharply, making them quite affordable.

But hold the celebration, there's need for caution here. In their over-enthusiasm to garner more and more business, banks and various other lenders are putting out advertisements that do not always give a complete picture about the overall cost of their loans.

The way the interest rate is defined and applied makes a lot of difference to the total amount of interest payable. It is important that we clearly understand the meaning of the words in 'small print' like flat rate, daily or annually reducing balance, etc, and also take into account 'other charges'. This is the only way to calculate the overall cost of the loan and then do a meaningful comparison with similar products from other lending institutions.

Flat rate
One of the most common interest systems is the flat rate. At first glance, this appears to be much cheaper. But if we understand the concept fully we realize that in many circumstances, one effectively ends up paying much higher interest. Under the flat rate system, interest is charged for the entire loan tenure. It does not take into account the fact that the principal amount keeps on reducing as you make EMI payments.

Suppose you were to borrow Rs1 lakh at 8 per cent flat rate for two years. The total interest works out to Rs16,000. The equated monthly installment (EMI) would then work out to Rs4,833.33 per month (Rs100,000 principal + Rs16,000 interest divided by 24 months).