Understanding your loan agreement and its clauses requires meticulous effort. You must check various parameters like loan amount, additional charges, EMI and foreclosure provisions. But it is the interest rate that deserves your special attention. There are different types of interest rates that the lender might levy on your loan. So, in addition to checking the interest rate you must also understand the type of interest rate and its impact on your loan.
The most common types of interest rates on a loan are flat interest rate and reducing interest rate. Read on to understand these interest rates in details.
What is the flat interest rate?
A flat interest rate is comparable to a simple interest rate. The rate is calculated on the total principal amount rather than the outstanding loan balance. A flat rate disregards periodic EMI payments and a reduction in the debt amount. Therefore, their total interest payable is a little higher.
How does a flat interest rate work?
Flat rate calculation is based on the following mathematical formula. Flat Interest Rate = (P × R × T)
Where, P is the principal loan amount, R means the rate of interest, and T refers to the repayment period
Let’s understand flat interest rate with an example –
Suppose you took out a personal loan of Rs 1,75,000 for 3 years. The lender approved a Personal Loan interest rate of 15%. In this case, the total amount of interest you will be paying is Rs 78,750.
What is reducing the balance interest rate on a loan?
A reducing rate on a loan is a type of financing arrangement in which your interest liability decreases with each EMI payment. It calculates interest on the outstanding loan balance rather than the original borrowing amount.
In the context of a loan, the reducing balance interest rate can be further classified as fixed or floating. The former remains unchanged till the loan conclusion, whereas the latter fluctuates according to market conditions.
How does a reducing interest rate work?
You can calculate it by applying the reducing interest rate formula outlined below.
EMI = [P x R x (1+I) ^ T] ÷ [((1+I) ^ T) -1)]
Where P is the principal loan amount, R means the rate of interest, and T refers to the repayment period
Illustration for a reducing rate of interest
Assume you applied for a Rs 2,00,000 used car loan with a term of 36 months. The interest rate on your loan is set at 11%. In this case, your EMI is–
EMI = [ 2,00,000 x 11% x (1 + 11%) ^ 36] ÷ [((1 + 11%) ^ 36) -1)]
EMI = Rs 6,548
Flat Rate vs Reducing Rate: Which is better?
As previously mentioned, a reducing rate is cost-effective. Now, let's understand this with an example.
Assume you have applied for a Rs 1,000,000 two-wheeler loan with a repayment term of 36 months. Your loan agreement specifies an interest rate of 8%. The table below shows the interest liability on both fixed and reducing rates.
Parameters
Reducing Balance Interest Rate
Flat Interest Rate
EMI
Rs 3,134
Rs 3,444
Total Interest Payable
Rs 12,811
Rs 24,000
Total Payable
Rs 1,12,811
Rs 1,24,000
If you opt for a reducing interest rate loan, you would be able to save Rs 11,189 in interest payment.
Difference between flat rate and reducing rate
You might have understood the primary distinction between reducing and flat rates by now. Let's take a quick look at the major distinctions.
Parameters
Fixed Interest
Reducing Interest
Calculation
It is calculated on the original borrowing amount.
It is calculated on the outstanding loan balance.
Formula
(P × R × T)
[P x R x (1+I) ^ T] ÷ [((1+I) ^ T) -1)]
Affordability
They are costlier.
They are affordable because the interest rate is levied on the balance dues.
Complex
They are easier to calculate.
They use a complex formula that makes calculation time-consuming and prone to error.
The type of interest calculation your lender uses has a direct impact on your EMI and budget. Flat rates might appear to be easy to understand, but in practice, they are much more expensive than reducing balance rates. Furthermore, you will hardly find any lender on the market offering flat rates.
Katyaini is a finance expert with a focus on the non-banking financial sector, bringing over 8 years of experience in NBFC. She specializes in simplifying complex financial concepts for readers, helping them navigate the NBFC landscape. Outside of work, she is passionate about travelling.
