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Understand the Difference Between Flat Interest rate vs. Reducing Interest rate

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Aug 16, 2021
Flat Rate v/s Reducing Interest Rate

Introduction to Flat Rate and Reducing Interest Rate

Non-banking financial companies (NBFCs) and banks offer different types of financial assistance for fulfilling the applicants’ monetary needs. The financial aid includes an MSME loan for business, home loan, corporate loan, or personal loan.

When we apply for a loan, lenders give us the option of a flat rate or a reducing interest rate. We fail to understand the implications of the interest rate choices, which results in losses, causing us to fear taking loans in the future.

Are you thinking of applying for a business loan or Term Loan? Read on to know whether you should opt for flat or reducing interest rates, which one is better, and the difference between the two.

Flat Rate and Reducing Balance: Know Everything

To help make a sound decision regarding the interest rate to select while going in for a loan, let us take a closer look at both flat rate and reducing interest rate options.

Whenever we take a loan of a specified amount, we have to pay interest on the same. However, some lenders try to misguide borrowers. Therefore, it is crucial to learn the difference between a flat interest rate and a reducing interest rate.

Let us first start by comprehending what interest is in loan amounts. It is a small portion of the loan amount that lenders ask the borrower to pay with the principal amount. Interest is calculated as a certain percentage of the loan amount. It is also known as the annual percentage rate and is a part of the monthly EMIs.

What is Flat Interest Rate?

A flat interest rate is a type of interest calculated on the entire amount of the loan. If you have applied for a business loan, the interest rate for business loans in India remains the same through tenure. Usually, flat interest rates are higher compared to reducing interest rates.

Benefits of Flat Interest Rate Loans

Easy to Track and Calculate

The flat rate calculation is quite simple. Loan commitments made per a flat interest rate are transparent and easily tracked by both parties, the lender and borrower. All the semi-financial institutions, such as village banks, self-help groups, and ASCA, offer flat MSME and corporate loan interest rates in India.

Flat Rate Loans Work Well to Meet the Financial Needs of Farmers

Many borrowers, including farmers, in developing countries look for loans that accept balloon payments. It is because a flat rate calculation is easier to understand.

Flat Rate Loans Favor In-kind Loan Transactions

The flat rate of interest concept came into existence before the invention of currency. It is the most common way of making regular instalments to repay the loan amount.

To give you a better idea, we have included tables that provide the breakdown of interest charged and principal repaid in both methods every month.

Formula for Calculating a Flat Interest Rate

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

Example of Flat Interest Rate

How Does the Flat Rate of Interest Work? 
Principal100000
Interest Rate12% p.a.
Loan Tenure3 years
Total Interest Paid36000
Interest Per Month1000
EMI3777.778

The EMI will be fixed over the entire loan tenure. Here is the yearly breakdown of the flat interest rate charged. One can use a flat interest calculator, also known as a flat rate EMI calculator, for this purpose.

Flat Rate
 EMIPrincipal RepaymentInterestBalance
13777.7782777.777778100097222.22
23777.7782777.777778100094444.44
33777.7782777.777778100091666.67
43777.7782777.777778100088888.89
53777.7782777.777778100086111.11
63777.7782777.777778100083333.33
73777.7782777.777778100080555.56
83777.7782777.777778100077777.78
93777.7782777.777778100075000
103777.7782777.777778100072222.22
113777.7782777.777778100069444.44
123777.7782777.777778100066666.67
133777.7782777.777778100063888.89
143777.7782777.777778100061111.11
153777.7782777.777778100058333.33
163777.7782777.777778100055555.56
173777.7782777.777778100052777.78
183777.7782777.777778100050000
193777.7782777.777778100047222.22
203777.7782777.777778100044444.44
213777.7782777.777778100041666.67
223777.7782777.777778100038888.89
233777.7782777.777778100036111.11
243777.7782777.777778100033333.33
253777.7782777.777778100030555.56
263777.7782777.777778100027777.78
273777.7782777.777778100025000
283777.7782777.777778100022222.22
293777.7782777.777778100019444.44
303777.7782777.777778100016666.67
313777.7782777.777778100013888.89
323777.7782777.777778100011111.11
333777.7782777.77777810008333.333
343777.7782777.77777810005555.556
353777.7782777.77777810002777.778
363777.7782777.77777810000.00

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.

Reducing Interest Rate 
Original principal100000
Interest rate12.00% p.a.
Loan tenure3 years
Principal outstanding100000
Loan amount100000
Total interest paid19571.52
EMI3321.431

Yearly Breakdown of the Reducing Interest Rate

Reducing Interest Rate
 EMIPrincipal RepaymentInterestReducing Balance
13321.4312321.430981100097678.57
23321.4312344.645291976.785795333.92
33321.4312368.091744953.339292965.83
43321.4312391.772661929.658390574.06
53321.4312415.690388905.740688158.37
63321.4312439.847292881.583785718.52
73321.4312464.245765857.185283254.28
83321.4312488.888223832.542880765.39
93321.4312513.777105807.653978251.61
103321.4312538.914876782.516175712.7
113321.4312564.304025757.12773148.39
123321.4312589.947065731.483970558.44
133321.4312615.846535705.584467942.6
143321.4312642.005001679.42665300.59
153321.4312668.425051653.005962632.17
163321.4312695.109301626.321759937.06
173321.4312722.060394599.370657215
183321.4312749.280998572.1554465.72
193321.4312776.773808544.657251688.94
203321.4312804.541546516.889448884.4
213321.4312832.586962488.84446051.81
223321.4312860.912831460.518143190.9
233321.4312889.52196431.90940301.38
243321.4312918.417179403.013837382.96
253321.4312947.601351373.829634435.36
263321.4312977.077365344.353631458.28
273321.4313006.848138314.582828451.44
283321.4313036.91662284.514425414.52
293321.4313067.285786254.145222347.23
303321.4313097.958644223.472319249.28
313321.4313128.93823192.492816120.34
323321.4313160.227612161.203412960.11
333321.4313191.829889129.60119768.279
343321.4313223.74818797.682796544.531
353321.4313255.98566965.445313288.546
363321.4313288.54552632.885460.00

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

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

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