Difference between flat and reducing interest rate

The three basic components of any loan are the principal amount, the tenure of the loan, and the interest rate applicable. The interest rate on personal loans is simply defined as the charges you pay when you borrow money from a lender.

For instance, when you take an instant loan from a financial institution like Finnable, the personal loan interest rates start at 16% up to 26%. These percentages change and vary depending on the type of lender you borrow from. 

However, you should know that you may have the option of taking a loan on a flat interest rate and reducing interest rate.

If you intend to take a personal loan but this concept is relatively new to you, you should first learn the difference between flat and reducing interest rates, the flat interest rate formula, and the method of calculating both.

What is Flat Rate of Interest?

When the interest rate is calculated on the full amount of the loan, it is termed a flat interest rate. It means that the rate of interest is calculated on the principal amount of the loan and will remain the same throughout the tenure.

Benefits of Flat Rate Interest

Having a flat interest rate on your personal loan has a multitude of benefits:

  • Easy calculation: Your EMI on the loan is determined when the loan is yet to be sanctioned. Having a flat interest rate on your loan makes it easy for you to calculate EMI, as it will be calculated on the full principal amount. 
  • Easy to understand: Flat rate calculations are easy to understand for borrowers.

 

How to calculate Flat Interest Rate

As mentioned, calculating flat rate interest is simple. To put it an example:

Mr. A has taken an education loan of Rs. 2,00,000 for 3 years from an FNB institution at 16% flat interest rate. To know his EMI, he will first need to calculate the interest. 

The flat interest rate formula is:

Principal Amount (P) x Rate of Interest (R)x Tenure of the loan (N) / number of installments 

= 2,00,000 x 16% x 3 / 36

= Rs. 2666.6

Once the interest has been determined on the loan, to calculate the EMI:

= Principal Amount (P) / number of installments

= 2,00,000 / 36

=Rs. 5555.5

Hence, the EMI will be:

= Rs. 2666.6 + Rs. 5555.5

=Rs. 8222.1

What is Reducing balance Interest?

The reducing balance interest method is when you calculate the interest on the diminishing principal amount. Every month when you pay your EMI, your principal amount reduces. When the interest is calculated on this new amount, at the time of EMI payment, you are using the reducing balance interest method.

Benefits of Reducing balance Interest

  • Reducing interest amount: One of the advantages of opting for a reducing interest rate is that the principal amount keeps reducing, thus reducing the interest that is applicable on the loan. 
  • Cost of Loan: By using the reducing balance method, the overall cost of the loan tends to be lower.

How to calculate Reducing balance Interest

  • To calculate the reducing balance interest, you will first need to know the initial interest rate on the loan. 

    Mr. B has taken a loan of Rs. 1,00,000 at 16% interest for 3 years.

    To calculate the interest:

    Principal Amount (P) x Rate of Interest (R)x Tenure of the loan (N) / number of installments 

    = 1,00,000 x 16% x 3 / 36

    = Rs. 1333.3

    EMI on this loan will be: 

    EMI= (P X R/12) X [(1+R/12) ^N] / [(1+R/12) ^N-1]

          = (100000*16%/12)*(1+16%/12)^36 / (1+16%/12)^36-1

         = Rs. 3515.7

    What you do need to remember is that the EMI will remain constant through the loan tenure. This has already been calculated on the principal loan amount. 

    Hence, the principal repayment amount will be:

    =EMI – Interest

    =3515.70-1333.33 

    =Rs. 2182.37

    The new principal will be:

    = Old Principal – New Principal repayment amount

    = 1,00,000 – 2182.37

    = 97,817.63

    Below is be the repayment schedule for the full loan duration: 

    Months 

    EMI 

    Principal Repayment 

    Interest 

    New Principal 

    1

        3,515.70 

                                                                2,182.37 

                      1,333.33 

            97,817.63 

    2

        3,515.70 

                                                                2,211.47 

                      1,304.24 

            95,606.16 

    3

        3,515.70 

                                                                2,240.95 

                      1,274.75 

            93,365.21 

    4

        3,515.70 

                                                                2,270.83 

                      1,244.87 

            91,094.37 

    5

        3,515.70 

                                                                2,301.11 

                      1,214.59 

            88,793.26 

    6

        3,515.70 

                                                                2,331.79 

                      1,183.91 

            86,461.47 

    7

        3,515.70 

                                                                2,362.88 

                      1,152.82 

            84,098.58 

    8

        3,515.70 

                                                                2,394.39 

                      1,121.31 

            81,704.20 

    9

        3,515.70 

                                                                2,426.31 

                      1,089.39 

            79,277.88 

    10

        3,515.70 

                                                                2,458.66 

                      1,057.04 

            76,819.22 

    11

        3,515.70 

                                                                2,491.45 

                      1,024.26 

            74,327.77 

    12

        3,515.70 

                                                                2,524.67 

                          991.04 

            71,803.10 

    13

        3,515.70 

                                                                2,558.33 

                          957.37 

            69,244.78 

    14

        3,515.70 

                                                                2,592.44 

                          923.26 

            66,652.34 

    15

        3,515.70 

                                                                2,627.01 

                          888.70 

            64,025.33 

    16

        3,515.70 

                                                                2,662.03 

                          853.67 

            61,363.30 

    17

        3,515.70 

                                                                2,697.53 

                          818.18 

            58,665.77 

    18

        3,515.70 

                                                                2,733.49 

                          782.21 

            55,932.28 

    19

        3,515.70 

                                                                2,769.94 

                          745.76 

            53,162.34 

    20

        3,515.70 

                                                                2,806.87 

                          708.83 

            50,355.47 

    21

        3,515.70 

                                                                2,844.30 

                          671.41 

            47,511.17 

    22

        3,515.70 

                                                                2,882.22 

                          633.48 

            44,628.95 

    23

        3,515.70 

                                                                2,920.65 

                          595.05 

            41,708.30 

    24

        3,515.70 

                                                                2,959.59 

                          556.11 

            38,748.71 

    25

        3,515.70 

                                                                2,999.05 

                          516.65 

            35,749.65 

    26

        3,515.70 

                                                                3,039.04 

                          476.66 

            32,710.61 

    27

        3,515.70 

                                                                3,079.56 

                          436.14 

            29,631.05 

    28

        3,515.70 

                                                                3,120.62 

                          395.08 

            26,510.43 

    29

        3,515.70 

                                                                3,162.23 

                          353.47 

            23,348.20 

    30

        3,515.70 

                                                                3,204.39 

                          311.31 

            20,143.80 

    31

        3,515.70 

                                                                3,247.12 

                          268.58 

            16,896.68 

    32

        3,515.70 

                                                                3,290.41 

                          225.29 

            13,606.27 

    33

        3,515.70 

                                                                3,334.29 

                          181.42 

            10,271.98 

    34

        3,515.70 

                                                                3,378.74 

                          136.96 

              6,893.24 

    35

        3,515.70 

                                                                3,423.79 

                          91.91 

              3,469.44 

    36

        3,515.70 

                                                                3,469.44 

                          46.26 

                    0.00 

Reducing Balance vs Flat Rate Interest

  • The difference between flat rate interest and reducing interest rate method at a glance: 

    Sr No

    Flat Rate Interest

    Reducing Interest Rate

    1

    Interest is calculated on the principal amount.

    Interest is calculated on the new principal, which is derived after payment of each EMI.

    2

    The interest amount and the principal amount will remain the same throughout the loan tenure.

    The interest amount, as well as the principal amount, will keep changing throughout the duration of the loan.

    3

    The calculation is simple.

    Calculating the interest with the reducing balance method can get a bit complicated. 

    4

    If you have chosen a flat rate interest loan, the total interest paid is more than the reducing balance method. 

    Unlike the flat rate method, the interest paid is reduced after each EMI paid. 

    5

    The total cost of the loan i.e. the interest plus EMI is high.  

    The total cost incurred on loans with a reduced balance method can be lower. 

    Just because it is easy to calculate does not mean that the flat rate method is suitable for you. Before the loan is sanctioned, it is better to speak to your lender and compare. 

    If you are looking for a loan without collateral, you should take a personal loan with an affordable interest rates. You should have the option for opting any kind of loan from the lender. Finnable provides various types of loans like education loan, vehicle loan, home renovation loans, etc. 

    Finnable’s personal loan interest rates start at 16%. Any of our loans can be applied via the online personal loan app. The process to get a loan is simple and can be completed within a few minutes. You will need to provide your KYC details and income slip. Once the papers are verified, the funds will be credited in a matter of hours.

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