# How a home loan works

BankBazaar.com

To understand how a home loan works one needs to understand what a rest means. A rest is the interval at which the remainder of the loan amount is recalculated as you repay the loan.

Financial institutions have various parameters surrounding the loan amount detailing the manner in which the loan is repaid. A Rest is nothing but the regular interval at which the loan amount balance is recalculated and also refers to the periodicity of compounding. This can be possible only in the case of reducing balance loan amounts.

These regular intervals or Rests can be yearly, monthly or even daily.

How to choose your home loan offer

For the twins Gayathri and Sanjana, fate intended that everything in their lives should happen in unison. Be it their first visit from the tooth fairy or their first job, the precision in timing was astounding. It so happened that they decided to buy their dream homes too around the same time.

The destiny that bound them together did not apparently bind their natures as Gayathri was very laid back and did not care too much for numbers, so she approached the first friendly bank who treated her like a queen, when she applied for a loan and took their best offer. Sanjana on the other hand did her research and had offers from several banks. Back at home Sanjana compared notes with Gayathri, who almost jumped for joy. She felt that she had landed an excellent loan bargain with minimum fuss, unlike her sister. After all, for the same loan amount of Rs. 20 L with a 20 yr loan tenure, Gayathri had an annualized interest rate of 12.75%, while the two loans that Sanjana had shortlisted from a bunch of loan offers, were both quoted at an annualized interest rate of 13%. However, Gayathris joy was short lived, when Sanjana explained how appearances can prove to be deceptive!

The loan offer Gayathri obtained was a flat rate loan. Banks can calculate their interest rates either at a flat rate or areducing balance rate. Sanjana on the other hand, had shortlisted two reducing balance loan offers with different rest periods. As her calculations revealed the loan offer with a monthly rest turned out to be a better loan bargain than the one with an annual rest. Let us examine these two aspects stated above in detail.

At a flat rate. the interest rates are calculated keeping the outstanding amount (i.e. the amount on which interest is calculated) constant throughout the loan tenure while in a reducing balance loan the interest rate is recalculated on a periodic basis based on the reducing outstanding loan amount.

Sanjana explained to Gayathri that at any given point in time, an X% flat rate is always more expensive than an X% annual reducing balance rate. Even in the case of a reducing balance loan a significant factor that impacts the loan cost is the time interval at which the reducing balance is recalculated, which could be monthly, daily, yearly, quarterly or half yearly. These time periods are known as rests, which denotes the regular interval at which the loan amount balance is recalculated and also refers to the periodicity of compounding. This can be possible only in the case of reducing balance loans.

The table below has the results of Sanjanas calculations that helped Gayathri calculate the

real cost of her loan.

Flat rate loan vs. Reducing balance loan

In the above table, a comparison between Column A and B reveals the difference in the impact between a flat rate loan and a reducing balance loan.

It is clear that the effective interest that Gayathri will need to pay up with her current loan offer is much higher amounting to 51 L while the loan offers Sanjana had zeroed in on for the same loan amount and tenure was much lower showing a difference of nearly Rs. 20 L in the interest paid out!

Choosing the offer with the ideal rest

To make the most of your reducing balance loan you need toensure the periodicity of repayment closely matches the frequency of your rest.

Sanjana was quick to realize this and her calculations revealed that a yearly rest or an annual rest would mean that even when you pay EMIs on a monthly basis on your loan, the loan amount based on which you pay the interest, will be recalculated only at the end of the year (12 months). This means you would continue to pay interest on the entire loan amount till that particular year (compounding period, when the outstanding loan amount is recalculated) ends, even when the outstanding loan amount reduces each month.

In the case of a monthly rest, the balance loan amount is recalculated and decreases every month. Hence it is to the advantage of Sanjana to take up a loan offer with the rest that more closely matches the frequency of her loan repayment. So if you are repaying your loan amount on a monthly basis, take up the loan offer that gives you the best rate on a monthly rest.

Banks generally quote an annualized interest rate, but remember that interest rates can be deceptive unless you figure out how they are defined. You can easily calculate the total amount of interest that you will pay for each offer by multiplying your EMI into the number of monthly installments and subtracting the loan amount from this figure. You can then easily identify which loan is the most cost effective for you. Remember to account for any upfront fees (e.g. processing fee) while comparing two loans.

What about daily reducing balance, you may wonder! Well, it makes sense to opt for a daily reducing balance only if you receive your income at different points of time during a month and can repay your loan at several or different points of time during a month. While this may not make sense for a salaried individual unless he or she has several sources of passive income, it becomes very relevant to self-employed people or individuals in a business that will have incoming funds atirregular intervals. For e.g. LIC has plans to launch a specific loan scheme for self-employed individuals where they can opt to pay daily or even quarterly payments.

In summary, the key to understanding your loan offers from multiple banks is to calculate the total amount of interest and fees you would pay for each offer and zero in on the offer that gives you the least total interest outflow.

BankBazaar.com is an online marketplace where you can instantly get the lowest loan rates. compare and apply online for your personal loan. home loan. car loan and credit card from India's leading banks and NBFCs.

Source: www.moneycontrol.com

Category: Credit

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