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

What is Reducing Rate of Interest?

A reducing rate of interest(also known as diminishing or declining interest rate) is calculated on the outstanding principal balance, which reduces with each EMI payment. As a result, the interest component of your EMI decreases over time, while the principal component increases. 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.

Let’s consider the same example as above, but with a reducing interest rate of 12% per annum:

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

EMI = [P x Ix (1+I) ^T]/ [((1+I) ^T)-1)]

where

• P = principal amount
• I = rate of interest / (100×12)
• T = number of years x 12

The EMI for a principal of ₹10,00,000 with a reducing interest rate of 12% per annum and a tenure of 5 years is approximately ₹22,244 per month

This process continues each month, with the interest component decreasing and the principal repayment component increasing. Over the 5-year tenure, the total interest outgo would be approximately ₹3,34,667.

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.

Differences Between Flat Interest Rate and Reducing Interest Rate

Parameter	Flat Interest Rate	Reducing Interest Rate
Interest Calculation	On the entire principal amount for the full tenure	On the outstanding principal balance, which reduces with each EMI payment
EMI Breakup	Fixed interest and principal components throughout the tenure	Decreasing interest and increasing principal components over the tenure
Total Interest Outgo	Higher compared to reducing rate for the same nominal rate	Lower compared to flat rate for the same nominal rate
Effective Interest Rate	Nearly double the nominal flat rate	Same as the nominal reducing rate

From the example above, we can see that for the same nominal rate of 12%, the total interest outgo is much higher with the flat rate (₹6,00,000) compared to the reducing rate (₹3,34,661).

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.

Factors Affecting Business Loan Interest Rates

1. Credit Score: A good credit score indicates a lower risk for the lender, which can result in more favourable business loan interest rates.
2. Business Vintage: Lenders often offer better rates to established businesses with a proven track record.
3. Loan Amount and Tenure: The loan amount and tenure can impact the interest rate offered by lenders.
4. Collateral: Secured loans, where you provide collateral, generally have lower interest rates compared to unsecured loans.
5. Lender’s Policies: Interest rates usually vary among lenders based on their risk assessment and lending policies.

How to Choose the Right Business Loan Interest Rate?

When choosing between a flat interest rate and a reducing interest rate for your business loan, consider the following factors:

1. Loan Tenure: If you opt for a longer loan tenure, a reducing balance rate may be more beneficial as it results in lower total interest paid over time.
2. Cash Flow: Assess your business’s cash flow projections to determine which interest rate option aligns better with your repayment capacity.
3. Total Cost of Borrowing: Use a business loan interest calculator to compare the total cost of borrowing under both interest rate options, factoring in the principal amount, tenure, and processing fees.
4. Prepayment Options: Check if the lender allows prepayment of the loan and any associated charges. Prepaying a loan with a reducing balance rate can lead to significant savings on interest.

Business Loan EMI Calculator: An Indispensable Tool

When comparing business loan interest rates, a business loan EMI calculator is an incredibly useful tool. It helps you quickly calculate your monthly EMIs for different loan amounts, interest rates and tenures.

FlexiLoans provides an online business loan calculator on its website. You simply need to input the loan amount, interest rate (flat or reducing) and tenure to get an instant estimate of your EMIs.

Using a business loan interest calculator can help you compare offers from different lenders and choose the most suitable one for your needs. It’s an essential step in financial planning for your business.

Conclusion

Understanding the difference between flat and reducing interest rates is crucial when applying for a business loan. While flat rates may seem attractive due to their simplicity, reducing rates often result in lower overall interest costs.

When choosing between the two, consider factors like affordability, total cost prepayment flexibility, and your specific business requirements. Don’t forget to use a business loan calculator to compare different offers and plan your repayments effectively.

If you’re looking for a hassle-free business loan or MSME loan with competitive interest rates, consider FlexiLoans. With minimal business loan documents required, quick processing and flexible repayment options, FlexiLoans is a trusted partner for MSMEs across India. Their user-friendly Business Loan EMI Calculator and Business Loan Interest Calculator make it easy to plan your borrowing.

Simplify your business funding journey today – apply for a collateral-free business loan with FlexiLoans in minutes!

FAQs

1. What is the difference between a flat interest rate and a reducing interest rate?
   While calculating interest, a flat interest rate considers the entire principal amount for the full tenure, regardless of the outstanding balance. On the other hand, lenders consider only the outstanding principal balance, while calculating EMI payments through a reducing interest rate.
2. Which interest rate type results in lower EMIs?
   For the same nominal rate and tenure, a reducing interest rate will result in lower EMIs compared to a flat interest rate. This is because the interest component of the EMI decreases over time with a reducing balance.
3. How does a business loan EMI calculator help?
   A business loan EMI calculator helps you quickly estimate your monthly EMIs for different loan amounts, interest rates and tenures. It’s a useful tool for comparing offers from different lenders and planning your repayments.
4. Can I prepay my business loan if it has a flat interest rate?
   Yes, you can prepay a business loan with a flat interest rate. However, many lenders charge prepayment penalties for flat rate loans, which can reduce the benefits of prepayment. It’s essential to check the prepayment terms before applying for a loan.
5. What documents do you need for a business loan application?
   The documents required for a business loan may vary depending on the lender and the type of loan. Generally, you’ll need to submit your business registration documents, income tax returns, bank statements, GST returns (if applicable) and KYC documents of the business owners / directors. Some lenders like FlexiLoans have minimal documentation requirements to simplify the application process for MSMEs.