Flat vs Reducing Interest Rate: Which is More Helpful?

Have you ever been surprised by how costly your loan turned out to be, despite a seemingly low interest rate? The real reason often lies in the way interest is calculated. Loans come with two types of interest rates: reducing and flat. These two rates function quite differently, and understanding them can help you avoid overpaying.

Borrowers who prefer fixed EMIs for easy calculations usually choose flat interest rates. Although this method gives you fixed EMIs, you may end up paying more interest overall compared to a reducing balance interest rate. 

With a clear understanding of these calculations, you can make wise choices and enjoy a comfortable repayment experience. 

Flat interest rate means the lender calculates interest on the entire original loan amount for the full loan tenure, regardless of any repayments made during the period. 

This method differs from reducing balance rates, where interest is calculated on the outstanding loan balance. With a flat interest rate, the interest amount remains the same throughout the loan term and does not decrease as the principal is paid down.

This method is common in:

• Personal loans

• Car loans

• Consumer durable loans 

Some of the key features include: 

• Fixed Interest Calculation: The lender will charge the rate on the original loan amount throughout the term

• Stable EMIs: Since the principal stays the same for interest calculation, EMIs remain fixed

• Common in Short-term Loans: Often used in loans with shorter repayment periods

Flat interest rate comes with benefits, such as:

• It is simple to understand and easy to calculate

• It has predictable EMIs, so planning and managing monthly budgets is easy

• It offers predictable repayments, although the actual interest paid may be higher than it appears

Most lenders offer EMI calculators that show your total payable amount. However, if you prefer to calculate it manually, you can use the flat interest rate formula:

Flat Interest = (Principal × Rate × Tenure) / 100

Example:

If you take a loan of ₹50,000 at 12% flat interest for 2 years:

• Interest Rate = (50,000 × 12 × 2) / 100 = ₹12,000

• Total repayment = ₹62,000 (excluding fees and charges)

Lenders calculate interest on the outstanding loan balance under a reducing interest rate method. As you repay the principal, they apply interest on the remaining amount. This lowers the interest you pay over time. This method benefits borrowers, especially for long-term loans. 

Some other benefits include: 

• You pay less interest over time, as the interest is calculated on the reduced principal balance

• You can track your repayments easily through the loan schedule

Use the following formula to calculate the EMI manually

EMI = [P × R × (1+R)^N] / [(1+R)^N – 1]

Where:

• P = Loan amount

• R = Monthly interest rate (annual rate/12/100)

• N = Loan tenure in months

When you apply for a loan, lenders may offer either a flat interest rate or a reducing interest rate. Both methods calculate interest differently, and each affects your total repayment amount. The table below highlights the key differences:

Choosing between a flat and a reducing interest rate depends on your financial priorities and how you plan to manage your loan.

If you prefer simplicity and fixed EMIs, the flat interest rate may be the right choice. This method offers:

• A predictable repayment schedule

• Fixed monthly payments and a clear idea for budgeting

• Ease of understanding and calculation

If you aim to reduce your total interest throughout the repayment period and need to repay the loan over a longer duration, consider the reducing interest rate approach. This method will provide:

• Lower interest over time 

• Better long-term savings, especially for high-value or long-term loans

• A more cost-effective repayment structure

Understanding the difference between flat and reducing interest rates is key when choosing a loan. To make the right choice, compare lenders, maintain a good credit score, and use EMI calculators. 

Which rate type is better for short-term loans?

Flat interest rates are more suitable for a short-term period as they are easy to understand and calculate. 

Which type of interest rate is best?

The ideal one will vary based on your financial priorities. If you prefer a loan with a predictable repayment schedule and fixed monthly payments, then a flat rate will be suitable. If you have a long-term loan and want to reduce the interest rate over time, then reducing the interest rate will be more suitable. 

Which type of FD gives the highest interest rate?

Small Finance Banks and NBFCs offer the highest FD interest rates compared to most commercial banks.

Does reducing the interest rate really save money?

Lower interest rates reduce the cost of borrowing, so it will lead to smaller EMIs and decrease the total interest you pay over the loan tenure. It will help you to pay the principal faster. 

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