Difference Between Flat and Reducing Interest Rate

Banks and Non-banking financial companies (NBFCs) offer different types of credit facilities to their customers, including MSME loans, home loans, personal loans, and so on. 

When you apply for a loan, the loan provider gives you two interest rate options, i.e. a flat rate or a reduced interest rate. 

Many borrowers are unaware of the differences between these two, resulting in losses and a fear of taking loans in the future.

When you take a loan, you have to pay interest on the borrowed loan amount. However, some lenders try to mislead borrowers. 

Whether you are thinking of applying for a term loan or business loan you should know which interest rate you should go for. 

In this article we have compiled the information on introduction, benefits and differences between flat and reducing interest rates, to help you make a sound decision while going in for a loan.

Interest is a small portion applied to the loan amount that lenders ask you to pay with the principal amount. Interest is a certain percentage of the loan amount, also known as the annual percentage rate (APR) and is a part of your monthly EMIs.

What is a Flat Interest Rate?

A flat interest rate is calculated on the entire loan amount. For example, if you apply for a business loan, the business loan interest rate in India remains the same throughout tenure. Usually, a flat interest rate is higher than reducing interest rate.

Benefits of Flat Interest Rate 

Easy to calculate: The flat interest rate calculation is simple. Loan payments made according to a flat interest rate are transparent and easy to track by lenders as well as borrowers. All the semi-financial institutions, including village banks, self-help groups (SHGs), and ASCA, offer flat interest rates on MSME and corporate loans in India.

Flat interest rate loans are better for farmers: Farmers and other such borrowers in developing countries like India look for loan options that accept balloon payments. This is because a flat interest rate calculation is easy to understand for them.

Flat rate loan means common transactions: The flat interest rate is the most common way of making regular loan instalments.

The Formula for Flat Interest Rate Calculation

Interest payable per Instalment = (Original loan amount x Number of years x Interest rate p.a.) / Number of instalments

Here is an illustration of how a flat interest rate works, to give you a better idea:

As you can see, the EMI will be fixed throughout the entire tenure under flat rate regime. You can use a Flat Interest Rate Calculator, also known as a Flat Rate EMI Calculator, for accurate calculation.

What is Reducing Interest Rate?

In a reducing interest rate, the interest reduces further if you pay partial amounts in the middle of the term. This interest rate method is also known as a diminishing rate of interest. In this method, the interest rate is calculated on the outstanding amount of the loan every month. When the principal loan amount reduces annually, it is called an annual rest.

Benefits of Reducing Balance Interest Rate

• The main benefit associated with a reducing interest rate is that, over time, the applicant has to pay lesser interest as compared to a flat interest rate loan. 
• One of the key advantages of opting for a reducing interest rate loan is that the principal amount keeps reducing, thus reducing the interest applicable on the loan. 
• By using the reducing balance interest method, the overall cost of the loan becomes lower.

The Formula for Reducing Interest Rate Calculation

Interest payable per Instalment = (Original loan amount x Number of years x Interest rate p.a.) / Number of instalments

Below is an example of how a reducing balance interest rate works, to give you a better idea:

As you can see from the above table, a flat interest rate does not give you as much of an advantage as a reducing balance interest rate.

You can use a Reducing Rate of Interest Calculator to do the calculation yourself. Free EMI calculators are available online on many lending and fintech websites for the convenience of the borrowers.

Differences Between Flat Rate or Interest and Reducing Rate of Interest 

• When you apply the flat rate method to calculate your loan interest rate, the initial principal is used for calculating the interest irrespective of the loan amount already paid or the remaining balance. In the reducing interest rate method, the interest is calculated based on the outstanding principal or remaining balance.
• A flat interest rate is usually lower than a diminishing interest rate. For example, if the lender charges a 12% flat rate and a 16% reducing interest rate, you will end up paying more overall interest cost in the 12% flat rate than in the 16% reducing interest rate during the loan’s tenure. 
• It is easy to calculate the flat rate using a Flat Interest Rate Calculator, in comparison to the Reducing Interest Rate.
• A reducing interest rate loan is better for borrowers compared to a flat rate loan as it offers the flexibility to prepay some portion of the loan to reduce their interest burden.
• Loans borrowed at reducing rates of interest usually have longer repayment tenures and flexible terms than those borrowed at flat rates of interest. 
• The EMI to be paid remains fixed for loans at flat interest rates, whereas the EMI payable monthly for loans availed of at reducing interest rates reduces over the loan tenure.

Conclusion

In a nutshell, lower rates of interest and an easy calculation process in flat interest rates may not be as beneficial as you would have thought. According to experts, even though flat interest rates are easy to understand, they are not favourable for borrowers to repay large loans. Therefore, before applying for any loan, make use of online calculators to check the interest charged on both options. This way, you will be able to make a well-informed decision.