When you apply for a loan, one of the most important factors to consider is the interest rate. The two most common types of interest rates in loans are flat interest rate and reducing balance interest rate. Understanding the difference between these two can help you make a more informed decision when choosing a loan. In this blog, we’ll break down both interest rate types and compare them to help you choose the best option for your financial needs.
What is a Flat Interest Rate?A flat interest rate is a method of calculating the interest on the full principal amount of the loan for the entire tenure of the loan. Regardless of how much of the loan you have repaid, the interest is calculated on the original loan amount throughout the repayment period.
How It Works:For example, if you take a loan of ₹10,00,000 at a flat interest rate of 10% for 5 years, the interest is calculated on the full ₹10,00,000 amount, not on the reducing balance. So, the annual interest will always be ₹1,00,000 (10% of ₹10,00,000), resulting in a fixed interest cost over the loan tenure.
Advantages of Flat Interest Rate:
- Fixed EMI Amount: Since the interest is calculated on the full loan amount, the EMI (Equated Monthly Installment) remains the same throughout the loan tenure
- Simple Calculation: The flat rate is easy to understand, making it more straightforward for borrowers.
- Higher Interest Costs: You end up paying more in interest compared to a reducing balance interest rate because the interest is calculated on the full principal amount.
- Not Ideal for Short-Term Loans: Since the interest is fixed and doesn’t decrease as you repay the loan, flat interest rates are typically more expensive for shorter-term loans.
A reducing balance interest rate is calculated on the outstanding principal loan amount. As you repay your loan, the principal amount reduces, and so does the interest cost. This means that the interest is charged on the remaining loan amount after each EMI payment, which can significantly reduce the total interest paid over time.
How It Works:For example, if you take a loan of ₹10,00,000 at a reducing balance interest rate of 10% for 5 years, the interest will be calculated on the remaining loan balance after every EMI payment. In the first year, the interest will be calculated on ₹10,00,000, but as you repay the loan, the outstanding balance reduces, and the interest amount decreases accordingly.
Advantages of Reducing Interest Rate:- Lower Interest Costs: Since interest is calculated on the outstanding principal, the interest amount reduces over time, making this type of loan cheaper in the long run.
- More Beneficial for Early Repayment: If you repay your loan early or make part payments, you will pay less interest overall.
- Higher Initial EMI: In the beginning, the EMIs are slightly higher than those of a flat rate loan because the interest is calculated on the reducing balance, and the loan balance is higher at the start.
- Complex Calculation: The reducing interest rate can be harder to understand because the interest amount changes over time.
| Factor | Flat Interest Rate | Reducing Balance Interest Rate |
|---|---|---|
| Interest Calculation | Based on the full principal amount | Based on the outstanding principal balance |
| Total Interest Paid | Higher over the loan tenure | Lower over the loan tenure |
| EMI Amount | Fixed throughout the tenure | Varies as the loan balance decreases |
| Ease of Understanding | Simple to calculate and understand | More complex due to changing interest over time |
| Ideal For | Simple to calculate and understand | More complex due to changing interest over time |
| Impact of Prepayment | No significant impact on reducing interest | Reduces the outstanding balance, lowering interest |
| Loan Tenure | Often suited for longer loan tenures | More beneficial for shorter loan tenures |
- You prefer predictable, fixed EMIs throughout the loan tenure.
- You have a long-term loan and can manage higher interest costs.
- You are looking for simplicity in understanding loan payments.
- You want to minimize the total interest paid over the loan tenure.
- You are planning to repay the loan early or make part payments
- You don’t mind slightly higher EMIs in the beginning to save on interest over time.
When deciding between a flat interest rate and a reducing balance interest rate, it’s important to consider your loan tenure, financial goals, and repayment capacity. Flat interest rates offer predictability, but they can lead to higher overall interest payments. Reducing balance rates, on the other hand, tend to be more economical in the long run, especially if you plan to repay the loan early.
At FinWelCo, we help you make informed decisions about loans and financial products that best suit your needs. Whether you’re looking for personal loans, business loans, or other financing options, we provide expert advice and assistance to guide you towards the right choice.
Contact us today to learn more about the best loan options for you, and let us help you find the best financing solution for your future!
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By Satish Chandra