Lenders calculate loan interest in two ways: flat interest rate and reducing interest rate. Both methods of calculation result in a different interest amount payable by you, the borrower.
In a nutshell, the difference between flat rate and reducing rate is as follows:
Flat interest rate: In a flat interest rate method, interest is calculated on the original loan amount (principal) throughout the loan tenure, irrespective of the repayments made. For example, if you borrow Rs. 1 lakh at a flat rate of 10% for three years, the interest is always calculated on Rs. 1 lakh, resulting in higher overall interest costs.
Reducing interest rate: In this method, interest is calculated on the outstanding loan balance after each repayment. As you pay EMIs, the principal reduces, and the interest amount decreases over time. For instance, a reducing rate of 10% on Rs. 1 lakh over three years results in lower total interest compared to a flat rate, making it more cost-effective.
Before you apply for a loan, understand what the two methods are and how they vary.
What is a flat interest rate?
A flat interest rate is calculated on the entire loan amount throughout the tenure of your loan. In this case, the interest rate or lending rate is fixed for the duration of your loan, and it will be calculated at the start of your loan tenure itself.
Flat interest rate formula
Interest calculation under the flat rate is based on the following formula:
Total Interest = (P * R * T)/100
where,
- P is the principal amount
- R show the annual interest rate (in percentage)
- T is tenure (in years)
What is reducing rate of interest?
The reducing interest rate is calculated on the diminishing principal amount. Every month when you pay your EMI, your principal loan amount decreases. And, when you opt for the reduced interest rate, the interest will be calculated only on the reduced principal amount at the time of EMI payment.
Each EMI you pay comprises an interest and principal component. Therefore each EMI paid lowers the outstanding principal balance. In this method, the interest calculation depends on the outstanding loan amount. Interest is calculated only on the outstanding principal liability and not the total principal borrowed.
Also, effective lending rates are taken into account. For better planning of your loan repayment journey, we suggest you use a personal loan EMI calculator and know your monthly EMIs in advance.
Reducing interest rate formula
Reducing interest rate calculation is based on the following formula:
Interest payable for each instalment = Outstanding loan amount x interest rate applicable for each instalment
As a thumb rule, if you prefer simple calculation and are risk averse, pick a loan with a flat interest rate.
With this understanding of the two interest calculation methods, take a look at the difference between a flat rate of interest and a reduced personal loan interest.
Read more: What is interest rate and how does it work?
Difference between flat and reducing interest rate
Typically, lenders offer two types of interest rates to borrowers – flat interest rates and reducing interest rates. Read on to understand the difference between the two.
1. Basis of calculation
Under a flat lending rate, interest is calculated on the total principal amount sanctioned, whereas interest accrual under a diminishing rate is based on the outstanding loan amount.
2. Effective interest rate equivalence
Fixed-rate calculations result in a higher effective interest rate equivalence. On the other hand, reducing rate calculation reflects the effective interest rate initially.
3. Rate comparison
Under the flat rate calculation method, interest rates are usually fixed at a lower percentage than diminishing interest rates.
4. Simplicity of calculation
Interest calculations under a flat rate are more straightforward than the reducing interest calculations.
These points of difference between flat and reducing interest rates outline how they can impact a borrower’s finances.
Now that you know how interest rate calculation can impact your finances, check the method of calculation with your lender before availing of a personal loan.
Which is better flat or reducing interest rate?
Choosing between a flat or reducing interest rate depends on your financial goals and preferences. A flat interest rate remains constant throughout the loan tenure, providing predictable monthly payments. In contrast, a reducing interest rate decreases as the outstanding loan amount decreases, potentially saving you money over time. Consider your financial situation, repayment capabilities, and long-term cost implications to determine which option aligns better with your needs.
Read more: Fixed vs floating interest rate
