When deciding on home loan the key driver for most of us is the interest rate in general. However, it’s not just the number on offer that matters, how the interest is calculated is also key as some banks can confuse you with the terms which can lead to you paying more over the life of the mortgage than if you had chosen a different product. In terms of Interest there are 2 terms to be looked at
Flat Rate Vs Reducing/Diminishing Interest Rates Flat Rate of Interest
As an example for a home loan of INR1,00,0000 with flat rate of interest of 4 %, the interest is set at INR40,000 per year over the term of the loan whether its first year or 15 the year.
Reducing Rates
In reducing Rates, for the same loan of INR1,00,0000 interest is recalculated at the beginning of each year based on the current loan balance. A reduced rate of 6% on a mortgage of 1,000,000 INR will seem higher in the first year, with 60,000 INR being generated in interest, but in fifteen years, if half the principle has been paid by that point, the interest will also be halved and only 30,000 INR will be added that year.
4 % flat rate and 6 % reducing rate example
First a look at a flat rate at 4%. This over-simplified example shows an initial balance of 1,000,000 INR paid at 100,000 INR per year with a flat rate of interest of 40,000 INR applied annually.
After 17 years, the loan is cleared and a total of 1,680,000 INR has been paid. The interest totalled 680,000 INR = equal to 17 annual interest additions of 40,000 INR.
FLAT RATE 4 % CALCULATION
REDUCING/DEMINISING - 6 % CALCULATION
Next a look at a higher reduced rate of 6%. Despite being a larger interest rate at the beginning, as the interest is calculated based on balance at the start of the year rather than the principle, the annual interest amount lowers each year
After 16 years, the loan is cleared and a total of 1,579,305 INR has been paid. Despite being a higher rate of interest, the reduced nature of the interest calculation means only 579,305 was paid in interest and the loan paid off a full year earlier – a saving of 100,695 INR
Which is better – flat or reduced rate?
Generally it is better to have a reduced rate, especially if the length of the loan is long as the reduction makes more impact the longer the term
Reducing rate is also far better if you plan to make additional payments on the mortgage, as these supplementary payments can substantially lower the interest calculated in later years.
A flat rate is only superior if the percentage rate offered is substantially lower than comparable reduced rate mortgages.
For reading about fixed/variable interest rate loans, please go to the link.
Cheers,
Sreekanth
0503963193
finplanuae@gmail.com
Credit- Multiple sources giving information on Mortgage Products
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