Loans offered by lending institutions attract one of the two kinds of interest rates: reducing balance rate and flat rate interest rate. It is important to know what sets both of these two apart so that you can decide which one will work best for you. Read on to know more.
A flat interest rate system is calculated on the entire loan amount beforehand. It does not account that the principal sum is reduced over the course of the repayment tenure. Hence, the EMI obligation remains static throughout the tenure if other factors remain constant.
It is calculated with the help of the following formula:
Interest= (Principal Amount x Flat Interest Rate (percentage or decimal) x Length of the repayment tenure (In years)) / Repayment tenure (Expressed in Months)
To illustrate with an example, let us just assume that Mr. Singh has secured a personal loan of ₹2,00,000 at a flat interest rate of 10% that he is going to repay over 10 years.
Given the above figures, the interest component of your monthly personal loan EMI outflow will look as follows:
(₹2,00,000 x 10% x 5)/60 = ₹1,666.67
So, your total interest payable over the course of your repayment tenure (5 years) will be:
₹1,666.67 x 60 (months) = ₹1,00,000
Now, let us add the principal amount to the above figure, which is another ₹2,00,000. So, the total amount that will be paid to the borrower will amount to ₹3,00,000. This will be paid off in 60 EMIs, so the borrower’s monthly outflow will be approximately ₹5,000 a month.
The interest rate which is calculated on the outstanding principal loan amount is known as the reducing or diminishing balance interest rate system. The EMIs of loans with this kind of interest rate are made up of two parts: outstanding principal amount and the interest calculated on the principal. The interest component of every instalment is calculated simply by multiplying the remaining loan amount to the interest rate per instalment.
The formula for the method is:
Interest = Outstanding loan amount x interest rate applicable for each instalment
Some differences between the two forms of interest rates are:
Particulars |
Flat Interest Rate System |
Reducing Balance Interest Rate System |
Basis of interest calculation |
Calculated on the total principal amount |
Calculated on the total remaining principal amount |
Interest liability |
Higher as compared to the interest charged under the reducing balance interest rate system |
Lower as compared to the interest charged under the flat rate system |
Level of complexity in calculation |
Simpler to calculate than in the case of the reducing balance system |
Relatively complex to calculate as compared to the flat interest rate system |
Who prefers them and why? |
The likes of farmers prefer the flat rate interest rate system as it is simple to calculate and understand |
People living in urban areas prefer the reducing balance interest rate system as the overall interest liability is lower as compared to the interest rate payable under the flat interest rate system |
Easy to Manage:
Since it is relatively simple to calculate and understand, it is easy for all parties involved to keep track.
EMI Obligation Remains Static:
Your monthly EMI obligation remains the same throughout the tenure, making it easier for you to plan your budget.
As you can imagine, borrowers that take up a loan with a reducing balance interest rate system pay a lesser amount as interest over time. This is because the interest component of every subsequent EMI is calculated on the outstanding loan amount.
Although relatively complex to calculate, it is clear that a personal loan with a reducing balance interest rate system will be more pocket friendly for you. You can avail one from Bajaj Markets itself through any of our lending partners. As a Bajaj Markets user, you will be able to enjoy benefits such as flexible repayment tenures, competitive interest rates and loan top ups. Apply Now!
FAQs:
What are the prominent differences between flat and reducing interest rates?
Flat rates are fixed on the full principal for the loan term, resulting in higher total interest. Reducing rates decrease as you repay the principal, leading to lower overall interest costs and payments over time.
What financial products do flat interest rates use?
Flat interest rates are commonly used for personal loans, auto loans, and certain types of business loans. They are often preferred for short-term financing. Flat rates are not majorly used for mortgage loans.
Which method is easier to calculate, Flat or reducing interest rates?
The flat interest rate method is easier to calculate, as it applies a fixed percentage to the entire principal amount for the loan duration. The reducing interest rate method requires recalculating the interest based on the decreasing principal balance, which can make the calculation comparatively complex.
