Flat Interest Rate Vs Reducing Rate: Know the Difference

The financial market consists of private and public banks that offer a wide range of loans, like housing loans, personal loans, car loans and more. These loans can be used to fulfil many life goals, like building a new home, funding a child’s education, covering wedding expenses or even cover travel costs. They are especially useful in case of a financial emergency like a medical bill or any other unforeseen expense. 

When you consider any type of loan, it is important to understand the type and how the interest rate is calculated. In this blog, we explore key differences between flat interest rates and reducing interest rates that include calculation, and its pros and cons. 

What is Flat Interest Rate?   

A flat interest rate is a fixed interest rate, and it remains the same for the entire loan tenure. It is calculated on the entire loan amount, and you still pay the same interest rate even though the principal amount decreases.  

The interest rate and monthly EMI amount remains the same. Flat interest rates are less common as compared to reducing interest rates. Additionally, they are also more expensive than reducing interest rates.   

How Flat Interest Rate Works 

In the flat interest rate, the interest is calculated on the entire principal amount for the entire loan tenure, regardless of how much loan amount has been repaid. While the EMI is consistent throughout the repayment period, it increases the total interest cost. Flat interest rates are commonly used for personal loans, auto loans, and consumer durable loans.     

Formula for Flat Interest Rate EMI Calculation:     

EMI = [(Principal + (Principal × Interest Rate × Tenure)] ÷ (Tenure × 12)  

Formula for Calculating the Flat Interest Rate   

To understand how a flat interest rate is calculated, let us consider an example. For instance, you take a loan of ₹5,00,000 at a flat interest rate of 10% per annum for 3 years.   

EMI is calculated as: 

Monthly EMI = [Principal + (Principal × Interest Rate × Tenure)] ÷ (Tenure in Months)   

= [5,00,000 + (5,00,000 × 10% × 3)] ÷ 36   

= [5,00,000 + 1,50,000] ÷ 36   

= ₹18,056 (approx.)   

You’ll pay ₹18,056 every month for 3 years, with a total interest of ₹1,50,000.  

Also Read: Interest Rate on a Personal Loan: Definition, How it Works & Example  

Advantages and Disadvantages of Flat Interest Rate   

Let us look into the advantages and disadvantages of flat interest rate:  

Advantages of Flat Interest Rate  

• Simple to Understand: Flat interest rates are easier to understand and calculate. 

• Fixed EMIs: The monthly payments remain constant, ensuring predictability. It helps to effectively manage finances as well.  

• Ideal for Small Loans & Short Term: Flat interest rate works well for small amounts and short loan tenure. It is costlier to get a loan at a flat interest rate for a large amount or a long tenure. 

Disadvantages of Flat Interest Rate  

• More Expensive: Flat interest rates are more expensive as compared to reducing interest rates, leading to higher overall interest rate 

• Limited Use: It is not an ideal loan for a long term loan or large loan due to higher cost. 

Flat interest rates are often preferred for short-term loans like personal loans or car loans, where fixed payments are prioritized over long-term savings. For long-term loans, reducing interest rates are usually more cost-effective.  

What is Reducing Interest Rate?   

A reducing interest rate is calculated on the outstanding principal amount, which decreases with each EMI payment. Thus, the borrower pays less interest over the loan tenure as the principal amount gradually decreases. 

Also Read: Fixed vs. Floating Interest Rate on Personal loan  

How Reducing Interest Rate Works   

In the reducing interest rate, with each EMI payment you make to the bank, the principal amount and the interest on it decreases. So, with each EMI, the principal amount that needs to be paid back decreases. Due to this, the interest component in subsequent EMI payments also decreases. Typically, the reducing interest rate is applied for housing loans, overdraft facilities and even credit cards.   

The formula for computing EMIs as per the reducing balance method is as follows.   

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

Here, P is the principal, I is the annual rate of interest, and T is the repayment tenure in years.   

Formula for Calculating the Reducing Interest Rate   

The formula for calculating EMIs as per the reducing interest rate is as follows.   

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

Here, P is the principal, I is the annual rate of interest, and T is the repayment tenure in years.  

Thus, for instance, if you take a personal loan of ₹5,00,000 with a reduced interest rate of 10% per annum for 3 years, your EMI for the first month would be around ₹16,667. As the principal gets repaid over time, the interest component decreases, and the EMI gradually shifts more towards repaying the principal. Over the 3-year tenure, the total interest paid would amount to approximately ₹1,21,250.   

Advantages and Disadvantages of Reducing Interest Rate   

Advantages of Reducing Interest Rate  

• Saving on Interest: As a borrower you pay less interest over the tenure of the loan. Due to this, you end up saving costs over the long term.  

• Cost Effectiveness: Borrower only has to pay interest on the outstanding loan amount. Thus, the EMI amount decreases with each payment. 

• Ideal for Long-Term Loans: Reducing interest rates are ideal for long term loans like home loans, personal loans and other such loan options as it offers flexibility and affordability. 

Disadvantages of Reducing Interest Rate  

• High Initial EMI: The initial EMI amount will be higher as it includes the larger portion of the outstanding amount.  

• Calculations have complexity: The monthly EMI payments may be difficult to understand for the borrower, as the interest is calculated each month based on the outstanding amount.  

• Not ideal for Short Terms: For shorter loan tenure, the interest saving might not be much as compared to flat rate loans 

Key Differences Between Flat and Reducing Interest Rates  

The key differences between flat interest rates and reducing interest rates are explained based on few factors:  

Flat or Reducing Interest Rate: Which is Better?

If you want to choose between a flat interest rate or a reducing interest rate, then it really depends on your financial requirement. Flat interest rate provides predictable and fixed monthly payments. This makes it easy to budget and manage other expenses. However, typically flat interest rates lead to higher overall interest costs.    

Reducing interest rate, on the other hand, is charged on the outstanding loan amount. This results in lower total interest paid overtime, and the monthly payments also reduce as the principal amount reduces. This option is ideal for long-term loans as it can save you money, especially if you repay early.   

Lastly, it is important to assess your current financial situation and weigh both options before making a decision.  

Conclusion   

Before you consider taking a loan, it is important to assess your financial goal and current financial situation. This helps you choose the type of loan and interest rate that best suits your financial requirements. A loan taken with a flat interest rate is ideal for a short-term loan or a smaller loan amount. Loans taken with a reduced interest rate are ideal for a long-term large loan like home loans, personal loans etc.