INTEREST
Interest, usually expressed in terms of a percentage, is the additional amount you pay for using borrowed money or the return you get when you invest it with an institution like a bank.Its also the compensation you can demand if someone delays a payment that’s due to you. If you think clearly, the two concepts we discussed earlier viz, time value of money and compounding were based on the concept of interest rates.In this post we are discussing certain practical scenarios where interest rates can baffle you. It’s discussed under two heads
1. Interest payments
2. Interest incomes.
INTEREST ON LOANS
Interest rates are always tricky. In most of the cases, interest rates advertised by the banks are not the actual rate of interest you pay. It’s something more than that.
Trap 1.
When you apply for a loan, there are a lot of financial charges you need to consider before deciding whether to avail it or not. For example – you are offered a loan for Rs.2 lakhs and your EMI works out to say, Rs. 18000 with 2 EMI’s payable in advance. Effectively, you are getting only Rs 164,000 in hand. But since the interest rate is calculated as if the entire 2 lakhs is given to you, the rate of interest you pay is actually very high.
Is that all? No. The bank will also deduct a processing fee of 1 % of the ‘total amount’ ie. Rs 2000 for a 2 lakhs loan. So on net, you get Rs 162,000.
Trap 2.
You are offered the same loan for reducing balance interest. You feel light thinking of the fact that interest is charged only on the balance outstanding. But look closer – reducing balance can be on monthly basis, half yearly basis or on Annual basis. If it’s on annual basis – your interest is calculated on the amount outstanding at the ‘beginning’ of the year. So, you keep paying interest on a higher amount even though your loan is decreasing every month. This pushes up the effective rate of interest you pay.So always confirm whether the reducing balance is on annual basis or half yearly basis.
Trap3.
Higher loan pre-closure charges. The bank would like you to pay your EMI’s regularly. If you do that, the bank likes you so much that on the basis of that regular loan track, they will sanction a second loan if you want. But – if you try to close off your loan liability before the stipulated loan period – the bank will charge an additional amount of 3% to 4% on the outstanding principal. They don’t want their customers to be ‘Too regular’. strange isn’t it?. That’s the way bank deals with it’s customers. If you try to be too good , you’ll be fined This preclosure charge you pay effectively raises the cost of your loan.
The solution-
The best way to deal with these traps is to stop comparing the interest rates and instead, compare the EMI’s and compute the total amount going out of your pocket including processing fee and pre-closure charges. This will give you the right picture of which loan is actually right for you.
INTEREST INCOME
The principle to be applied is quite simple – The earlier you get it, the better it is.
This principle will help you to compare different offers. For example – A bank offers 8% P.a interest on FD , payable annually. NSC also offers 8% P.a but, payable half yearly. You get another offer on FD which pays interest at 8% p.a – payable monthly. Which is better? The one you get on monthly basis, of course!. Why? Because, the bank’s effective rate is 8% , the NSC’s effective rate is 8.16% and the third option of FD gives you an effective annual interest rate of 8.30% !
How? Let’s calculate with an example –
Interest, usually expressed in terms of a percentage, is the additional amount you pay for using borrowed money or the return you get when you invest it with an institution like a bank.Its also the compensation you can demand if someone delays a payment that’s due to you. If you think clearly, the two concepts we discussed earlier viz, time value of money and compounding were based on the concept of interest rates.In this post we are discussing certain practical scenarios where interest rates can baffle you. It’s discussed under two heads
1. Interest payments
2. Interest incomes.
INTEREST ON LOANS
Interest rates are always tricky. In most of the cases, interest rates advertised by the banks are not the actual rate of interest you pay. It’s something more than that.
Trap 1.
When you apply for a loan, there are a lot of financial charges you need to consider before deciding whether to avail it or not. For example – you are offered a loan for Rs.2 lakhs and your EMI works out to say, Rs. 18000 with 2 EMI’s payable in advance. Effectively, you are getting only Rs 164,000 in hand. But since the interest rate is calculated as if the entire 2 lakhs is given to you, the rate of interest you pay is actually very high.
Is that all? No. The bank will also deduct a processing fee of 1 % of the ‘total amount’ ie. Rs 2000 for a 2 lakhs loan. So on net, you get Rs 162,000.
Trap 2.
You are offered the same loan for reducing balance interest. You feel light thinking of the fact that interest is charged only on the balance outstanding. But look closer – reducing balance can be on monthly basis, half yearly basis or on Annual basis. If it’s on annual basis – your interest is calculated on the amount outstanding at the ‘beginning’ of the year. So, you keep paying interest on a higher amount even though your loan is decreasing every month. This pushes up the effective rate of interest you pay.So always confirm whether the reducing balance is on annual basis or half yearly basis.
Trap3.
Higher loan pre-closure charges. The bank would like you to pay your EMI’s regularly. If you do that, the bank likes you so much that on the basis of that regular loan track, they will sanction a second loan if you want. But – if you try to close off your loan liability before the stipulated loan period – the bank will charge an additional amount of 3% to 4% on the outstanding principal. They don’t want their customers to be ‘Too regular’. strange isn’t it?. That’s the way bank deals with it’s customers. If you try to be too good , you’ll be fined This preclosure charge you pay effectively raises the cost of your loan.
The solution-
The best way to deal with these traps is to stop comparing the interest rates and instead, compare the EMI’s and compute the total amount going out of your pocket including processing fee and pre-closure charges. This will give you the right picture of which loan is actually right for you.
INTEREST INCOME
The principle to be applied is quite simple – The earlier you get it, the better it is.
This principle will help you to compare different offers. For example – A bank offers 8% P.a interest on FD , payable annually. NSC also offers 8% P.a but, payable half yearly. You get another offer on FD which pays interest at 8% p.a – payable monthly. Which is better? The one you get on monthly basis, of course!. Why? Because, the bank’s effective rate is 8% , the NSC’s effective rate is 8.16% and the third option of FD gives you an effective annual interest rate of 8.30% !
How? Let’s calculate with an example –
- Let’s assume that you have 2 lakhs with you.
- The first bank would give you 8% – annually so, you receive an interest income of Rs.16,000 at the end of one year.
- Suppose you depoited the same with NSCThey would give you 8% -half yearly. So, at the end of 6 months you get Rs 8,000 which can be again invested for 8% interest for 6 months whch gives you an additional interest of Rs. 340. So, the total interest you receive is now Rs 16,340. effective rate – 8.16%
- Similarly , when you work out 8% interest received on a monthly basis the effective interest rate would workout to 8.30%
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