It is important to grasp the type of loan and how interest on this loan is determined. This blog examines the principal differences between flat vs reducing interest rates, including their advantages.
What is a Flat Interest Rate?
A flat interest rate refers to an interest that remains fixed for the entire term of the loan. This means that the interest is computed on the full principal amount right from the beginning of the loan period. Therefore, such interest remains unchanged during the term of the loan, regardless of payments made at any time.How Does a Flat Interest Rate Work?
The flat interest rate method calculates interest using this formula:Flat Interest Rate = (P × R × T)
Where:P = Loan amount (Principal)
R = Interest rateT = Loan tenure (in years)
Example:Let’s say you take a personal loan of ₹1,75,000 for 3 years at an interest rate of 15% per year.
Step 1: Calculate Total InterestInterest = (1,75,000 × 15% × 3) = ₹78,750
Step 2: Find Total Amount to RepayTotal Payable = Principal + Interest = ₹1,75,000 + ₹78,750 = ₹2,53,750
Step 3: Calculate EMI (Equated Monthly Installment)EMI = Total Payable ÷ (Loan tenure in months) = ₹2,53,750 ÷ 36 = ₹7,049 per month
So, under the flat rate method, you will pay ₹7,049 every month for 3 years.Benefits of Flat Interest Rate:
Borrowers find choosing a flat interest rate on personal loans to be an attractive option due to its many advantages. These consist of:The ability to calculate EMI is one of the primary advantages of a flat interest rate. With a set interest rate and the ability to search the entire original amount during the loan time, borrowers may easily examine their monthly payments. This little computation can assist in simplifying the refund procedure.
A better financial strategy is aided by a flat interest rate. Borrowers can precisely arrange for their monthly financial responsibilities because EMI stays constant.
The ability for borrowers to lower their EMIs through prepayment is another benefit of a flat interest rate.
Flat interest rate calculations are typically simple to comprehend, which is particularly advantageous for first-time loan applicants. This approach makes interest more understandable and accessible to all kinds of borrowers.
What is Reducing Interest Rate?
One technique for figuring out interest on a loan based on the remaining principal balance is reducing interest rates. A portion of your monthly EMI payment is used to lower the principal balance. Over time, your interest payments will drop because the interest is computed on this reduced sum.How Does a Reduced Interest Rate Work?
The reducing balance method calculates EMI using the following formula:EMI = [P × R × (1 + R) ^ T] ÷ [(1 + R) ^ T - 1]
Where:P = Loan amount (Principal)
R = Monthly interest rate (Annual rate ÷ 12)
T = Loan tenure (in months)
Example:Suppose you take a used car loan of ₹2,00,000 for 36 months at an annual interest rate of 11%.
Step 1: Convert Interest Rate
Since the EMI formula uses the monthly interest rate, divide the annual rate by 12: 11% ÷ 12 = 0.9167% per month (or 0.009167 in decimal form). EMI = [2,00,000 × 0.009167 × (1 + 0.009167)³⁶] ÷ [(1 + 0.009167)³⁶ - 1] After solving, the EMI comes to ₹6,548 per month. By reducing interest rates, based on principal balance the interest calculation is done rather than the original loan amount. Reducing interest rates can result in sufficient savings. The remaining technique only calculates interest on the outstanding amount, which results in low overall interest expenses, in contrast to a flat interest rate loan, which calculates interest on the full loan amount. The borrower may be able to pay off debts quickly because monthly payments can be lowered gradually with each installment. When you go for a loan, the right interest rate is really important because it determines the cost of repayment. The two basic types of interest rates, flat and reducing, vary greatly in how the interest amount is calculated, thus affecting EMIs and loan tenures. Here's a breakdown to help you grasp the distinction between flat vs reducing interest rates.Benefits of Reducing Interest Rate?
The following advantages are offered by reducing interest rates:
Differences between Flat vs Reducing Interest Rates?
Factor
Interest Calculation
Flexibility in Repayment
EMI Payment
Flat Interest Rate
Interest is calculated on the full loan amount at the start and remains fixed throughout the loan term.
Fixed EMI throughout the loan tenure, offering stability but no cost reduction benefits.
Remains constant throughout the loan term, providing predictability.
Reducing Interest Rate
Interest is calculated on the remaining principal balance, reducing as payments are made.
EMI decreases over time as the principal reduces, making it more cost-effective in the long run.
EMI decreases gradually since interest is charged only on the remaining loan balance.
Conclusion
In conclusion, the choice between flat and reducing interest rates depends on your financial goals. If you prefer stability with fixed monthly payments, a flat interest rate is a suitable option. However, if you aim to reduce overall interest costs and benefit from lower EMIs over time, a reducing interest rate can be a smarter choice. Evaluating your budget and repayment capacity will help you make the right decision.
