Flat Interest Rate Vs. Reducing Rate of Interest – Understand the Difference

What is Reducing Rate of Interest?

In reducing rate of interest, the interest reduces further if partial amounts are paid in the middle of the term. It is also known as a diminishing interest rate. Here, the interest rate is calculated on the outstanding loan amount each month. When the principal amount reduces annually, it is known as annual rest.

Benefits of Reducing Balance Loan Interest Rate

The primary benefit associated with a reducing balance interest rate is that as time passes, the applicant has to pay lesser interest compared to flat interest rate loans. However, in the case of a flat rate, the loan will be repaid in a shorter duration, so the interest for the months that have been paid in advance need not be paid. However, in reducing interest rate, the duration of repayment and the interest component will also be impacted.

Formula for Calculating the Reducing Interest Rate

Interest payable per Instalment = (Original loan amount x No. of years x Interest rate p.a.) / Number of instalments

Illustration of Reducing Interest Rate

The following example is for a three-year loan. However, your loan tenure may range up to even 30 years. When the loan tenure is 30 or 20 years, we are likely to pre-pay our loan. A flat interest rate does not give as much of an advantage as a reducing interest rate.

Yearly Breakdown of the Reducing Interest Rate

You can also make use of a reducing rate of interest calculator to save time and effort, instead of doing manual calculations. Free calculators are available online on most lenders’ websites for the convenience of the borrowers.

What Do We Observe from the Above Calculations?

In the above example, the principal amount, interest rate, and tenure are the same. However, the EMI for the flat rate is higher than that of the reducing interest rate option. The EMI for the flat rate is INR 3778, while it is INR 3321.431 for the reducing interest rate. Note that both options are provided at a 12% interest rate. For such transactions, a large number of flat and reducing rate of interest calculators are available online. You can adjust the principal, interest rate, and tenure in these calculators and see how the interest and EMI for the flat rates and reducing interest rates differ.

Differences Between Flat Interest Rate and Reducing Interest Rate

1. When using the flat rate method to determine your Mudra loan interest rate or business loan interest rate, the initial principal is used to calculate the interest irrespective of the amount already paid or the balance remaining. In the case of the reducing interest rate method, the interest is calculated based on the principal outstanding or balance remaining.

2. Flat interest rates are usually lower than diminishing interest rates. Assume the lender will charge a 12% flat rate and an 18% reducing interest rate. However, you will end up paying more interest overall in the 12% flat rate than in the 18% reducing interest rate over the loan’s tenure. 

3. It is easy to determine the flat rate using a flat rate interest calculator, compared to the reducing interest rate.

4. A reducing interest rate is better from the borrowers’ perspective compared to a flat rate as it offers the flexibility to prepay a certain portion of the loan to reduce the interest burden.

Conclusion

In a nutshell, lower interest rates and the simplicity of calculation in flat rates may not be as beneficial as previously thought. Experts believe that even though flat rates are easy to understand, they prove to be misleading for repaying large loans. Therefore, before applying for a loan, take the help of online calculators to verify the interest charged on both options. After that, make an informed decision. Furthermore, if you have any doubts, you can reach out to FlexiLoans. We help in clarifying the interest calculation method of both flat interest rates and reducing interest rates.