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Flat Rate v/s Reducing interest rate

3 Min Read
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Author - Sanyam Jain
Flat Rate v/s Reducing interest rate

Interest is a portion of the loan amount over and above the principal amount repaid to the lender. Interest rate is a percentage of the loan, calculated annually, also known as Annual Percentage Rate (APR). Thus, each EMI repayment has a portion that goes towards the principal amount and the quantity which goes towards the interest component.

There are different ways in which interest rates can be calculated.

Did you know? A loan with a flat rate of 14% is significantly costlier than a loan with a reducing rate of 14%. Let us look at an example to understand this better.

Suppose you take a loan of Rs 6 lakh at a 14% Flat rate for five years. Since the rate is fixed, you will be paying the same interest amount from the first EMI until the last despite the constant reduction in the borrowed amount.

Thus, you end up paying Rs 1.8 lakh more as interest than what would have been in the case of availing the same loan at a 14% Reducing Rate.

Before borrowing - be it a Personal Loan, a Car Loan, or a Two-wheeler Loan - you can simply find out the difference between Flat and Reducing rates - and then decide which one is better. But, first, let us look at the meaning of these two types of interest calculations to understand their differences better.

Flat Interest Rate:

Under Flat interest rate, the lending rate remains unchanged throughout the loan repayment tenure. Therefore, the interest component for EMI is calculated on the total amount of the loan borrowed initially.

Simply put, interest is calculated on the original loan amount throughout the loan tenure.

So even if you pay EMIs, which is a combination of interest and principal repayment, the interest calculation is always done on the original loan amount at the rate quoted.

Since this interest component does not reduce with the repayment, a flat rate of interest usually leads to higher repayment liability.

To calculate interest under Flat rate, we use the below-mentioned formula:

(Loan principal * Total Loan Tenure * Interest rate per annum) / Total number of instalments

Reducing Interest Rate:

Under Reducing interest rate, also known as Diminishing/ Reducing Balance interest rate, the interest component is determined based on the outstanding loan amount.

Since the outstanding amount changes with each EMI paid, the interest factor also changes with each EMI.

In contrast to the flat-rate method, interest is calculated on the outstanding loan amount at the end of every month. Therefore, with every EMI, your loan outstanding is reduced, and interest is calculated on the reduced loan amount, thus reducing your total interest outgo compared to the flat method.

To calculate interest under Reducing rate, we use the below-mentioned formula:

Interest Payable = Outstanding Loan Amount * Interest rate (as agreed upon)

Now that we have understood the two types of interest rates, let us compare the two:

Flat rate v/s Reducing rate:

  • Basis of Calculation: Under the Flat Rate, interest is calculated on the total loan amount. On the other hand, the interest is calculated on the outstanding loan amount under the Reducing Rate.
  • Effective Interest Rate: Interest rate calculation under Reducing rate provides an effective interest rate initially. In contrast, the calculations under Flat-rate provide a better effective interest rate for the tenure of repayment.
  • Rate Comparison: Interest rates under the flat rate calculation method are usually fixed at a lower percentage than diminishing interest rates. However, this can be misleading, and you must pay attention to its effects in the long run before settling.
  • Simplicity of Calculation: Calculating interest under a Flat Rate is less complicated and more straightforward than the Reducing Rate interest calculations.

You must be wondering by now, what should we do? Which rate is better? Well, let us find out-

Financial Experts and the Reserve Bank of India (RBI) recommend quoting reducing rates as they are transparent and reflect the effective cost of the loan compared to the flat rate, which seems to be easy to understand but can be misleading.

When going for a loan, always check the method of the interest rate calculation. Banks and all large NBFCs typically quote reducing rates. However, a few smaller NBFCs and loan app providers may quote flat rates. Therefore, always compare on a like to like basis (flat to flat and reducing to reducing) before deciding.

So, before availing of a loan, make sure that you keep these points in mind and check with your lender about which method of interest calculation they use.

Still in doubt? Reach out to us. We will guide you through the interest rate calculation method by the selected banks and help you complete all technicalities related to taking a loan.

Drop in your request here .

About Author

Sanyam Jain
Highly motivated and utterly skilled, a young and zealous writer trying to follow his passion for the love of the English language. Written for different niches for over three years, now writing for the finance sector. When writing for a financial product you learn a new thing everyday.

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