Does Your Interest Burden Reduce When You Pay Monthly EMIs?
For Sharad Gupta, 28, the process of loan approval by his bank seemed like a long and tiresome one. The exhausting process of document collections, verification, etc, was over and he could now look forward to becoming a homeowner.
However, this euphoria was shortlived. As the EMIs took their toll the joy of being a home owner subsided and financial restraints made him doubt his financial planning.
Why does'nt the annual interest on his home loan reduce despite the principal loan amount shrinking every month as he pays his EMIs (equated monthly installments) regularly?
On checking his loan document, Gupta noticed that his bank is using the annual reducing balances method for loan recalculation. This means Gupta ends up paying the same interest on a less loan amount. He did not have to be a finance wizard to know this. He should have opted for a monthly reducing balance method when he signed the home loan papers with the bank.
Let us simplify this for you further. You take a loan of Rs 10 lakh from a bank on which you are paying an interest of say Rs 1 lakh over five years. Now, when you start paying the EMI and the Rs 10-lakh amount is reduced by Rs 15,000 a month, should your bank not factor this in and deduct the interest accordingly? Apart from the financial loss that an annual reducing method of interest causes you, it also seems a bit unfair, does it not? This is why it is imperative you ask questions and do not be satisfied till you have been given a clear answer. And the answer to which period you should opt for when your bank wants to apply reducing balance method, make sure you tick on the monthly mode.
A visit to the Reserve bank of India's FAQ (frequently asked questions) page would also inform you so.
“Borrowers benefit more from a loan that's calculated on a monthly reducing basis than on an annual basis,” the answer under the question 'what is monthly reducing balances method?' reads.
“In case of monthly resets, the interest is calculated on the outstanding principal balance for that month. The principal paid is deducted from the opening principal outstanding balance to arrive at the opening principal for the next month, and the interest is computed on the new, reduced-principal outstanding.”
On the other hand, “in case of annual resets, the principal paid is adjusted only at the end of the year and you continue to pay interest on a portion of the principal that has been paid back to the lender”.