It is very easy getting a personal loan these days. You can walk into a bank or a consumer finance company and get a loan in a very short period of time. Or it can be the other way round as well. A direct sales agent can come to you and convince you to take a personal loan.
While convincing you to take a personal loan, the bank or the direct sales agent is likely to tell you that the rate of interest charged on these loans is in the region of 20-25%. The logic given is something like this:
Let us say an individual decides to take a personal loan of Rs 75,000 to be repaid over a period of three years. You are told that to repay this loan you would have to pay an amount of Rs 3,400 every month.
Hence, over a period of three years, the total amount you would have paid would work out to Rs 122,400. Of this Rs 75,000, is the loan that you have taken. Hence, you pay an interest of Rs 47,400 (Rs 122,400 - Rs 75,000) over a period of three years.
An interest of Rs 47,400 works out to Rs 15,800 (Rs 47,400/3) per year. An interest of Rs 15,800 in a year on a loan amount of Rs 75,000 implies an interest rate of around 21%. This figure is arrived at by dividing Rs 15,800 by Rs 75,000 and expressing this as a percentage.
Banks and direct sales agents call this way of expressing interest is known as the flat rate of interest.
But this is not the right way to calculate interest. Banks and consumer finance companies in their zeal to give you the loan do not tell you the truth. In order to repay the loan, you have to pay a certain amount every month to the bank, or the consumer finance company, you have taken the loan from. Every month when you make this payment a certain part of the principal amount -- i.e. the actual loan that you had taken -- gets repaid.
Given this, the interest is to be calculated on the loan outstanding at any point in time, instead of on the principal. This is the right way of calculating interest and is known as the reducing balance method of calculating interest.
When this method is used to calculate interest the actual rate of interest is the example taken above comes to 35%.
Hence, the actual interest rate that you are paying on the loan is almost 15% higher than what banks and consumer finance companies lead you to believe.
For charging such a high rate of interest, the reason usually offered is that personal loans are unsecured, i.e. the individual taking the loan does not need to offer them a security. And since giving out such loans is risky business, the rate of interest is high.
The explanation is acceptable. But what is not acceptable is the fact that banks and consumer finance companies charge a rate of interest as high as 35% on their personal loans and tell their borrowers that the rate being charged is as low as 20%.
This clearly is a marketing ploy. It is easier to get people to borrow at lower rates than at higher rates.
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