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

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

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.

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.

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.

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

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

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