In simple terms, when you take out a loan for a set period of time, you must repay both the principal and the interest within that time frame. Aside from the loan rate, you must understand how the bank will calculate interest on your mortgage. The two most common methods for calculating interest on loans are the flat interest rate method and the decreasing balance interest rate method.
It’s much more important to know how to compute this in advance in a hazy situation like this, when no bank employee would provide you the actual interest rates or other facts. In simple terms, if you take out a loan for a set period of time, you must repay both the principal and the interest within that time frame. Aside from the loan rate, it’s crucial to comprehend how the bank will calculate interest on your mortgage. The two most common methods for calculating interest on loans are the flat interest rate methodology and the decreasing balance interest rate strategy.
What is Flat Interest Rate?
A flat interest rate refers to a rate of interest that is determined on the full loan amount. If you apply for a business loan in India, the interest rate will remain the same throughout the duration of the loan. Flat interest rates are usually more expensive than interest rates that are being reduced.
In this case the personal loan interest rate is calculated on the initial principal amount without accounting for the principal repaid. This method of interest calculation results in a higher EMI. This can be understood better with the example below,
Let us assume you take a Rs. 1, 00,000 loans at 10% interest rate. The interest component for every year would be 10,000/-. So in case you would like to repay the loan in 3 years, the total of the principal amount and the interest rate would be Rs 1,00,000/- + Rs, 30,000/- i.e. Rs 1,30,000/- This will be divide by 3 years i.e. a total Rs 1,30,000/- divided by 36 months i.e. Rs. 3612 per year. The same in case of a reducing balance approach would be would be Rs. 3227/-. This best personal loan interest rate you can look for in the case of some private lenders for a quick loan.
Example of Flat Interest Rate
| Principal | 100000 |
| Interest Rate | 12% p.a. |
| Loan Tenure | 3 years |
| Total Interest Paid | 36000 |
| Interest Per Month | 1000 |
| EMI | 3777.778 |
Advantages and Disadvantages of Flat Interest Rates
- Even laypeople who may not have enough knowledge about financial transactions can borrow at flat interest rates. Moreover, by availing of loans at flat interest rates, there is no need to estimate how much you would pay every month.
- Furthermore, even if you need to estimate your EMIs, many online calculators are at your disposal. More importantly, the process involved is much simpler than reducing interest rates.
- However, borrowing at flat interest rates does not come without disadvantages. One of the biggest setbacks of flat interest rates lies in its meaning. People, especially laymen, may get mixed up with ‘fixed’ and ‘flat’ interest rates.
- The two terms, although used interchangeably, are far apart from each other. ‘Flat rate’ refers to the overall cost of lending money and, as such, is not an interest rate.
Benefits of Flat Interest Rate Loans
- Tracking and calculating are simple
- Flat-rate loans are a good way for farmers to get the cash they need
- In-kind loan transactions are preferred by flat rate loans
What is Reducing Interest Rate?
A reducing rate for a personal loan calculates interest on the principal amount outstanding at the conclusion of a given term, as opposed to fixed vs. lowering rates. As you pay your EMIs, a portion of your principle is lowered, and the remainder is used to pay interest. The interest rate for the next month will change since it will be based on the new principle owed.
For example, if you obtain a loan of Rs 1,00,000 for 5 years at a lowering rate of interest of 10% p.a., your EMI cost would decrease with each payments. You would pay Rs 10,000 in interest the first year, Rs 8,000 on a decreased principle of Rs 80,000 the second year, and so on, until you only paid Rs 2,000 in interest the last year. You would pay Rs. 1.3 lakh instead of Rs. 1.5 lakh, as opposed to Rs. 1.5 lakh if you used the fixed rate option.
Example of Reducing Interest Rate
| Original principal | 100000 |
| Interest rate | 12.00% p.a. |
| Loan tenure | 3 years |
| Principal outstanding | 100000 |
| Loan amount | 100000 |
| Total interest paid | 19571.52 |
| EMI | 3321.431 |
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.
Can you convert your Flat Interest Rate into Reducing Balance?
If you have a fixed-rate personal loan and wish to convert it to a declining balance, you need first contact your lender and request this. If it agrees, it may be able to relieve you of some of your interest commitments. If it doesn’t, you might consider transferring the existing loan balance to another lender with a lower interest rate and a lesser sum. The new lender will review your loan statement to see how much money you owe, how much you’ve paid in principle and interest, your credit score, and so on. Because the loan is unsecured, the lender will require a credit score of 700 or above to approve the personal loan sum.
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.
- 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.
- For a fixed interest rate loan, the calculation will be based on the total amount sanctioned whereas for a reducing balance loan it will be based on the principal amount that is outstanding.
- The loan tenure of a fixed interest loan will usually be longer than that of a reducing balance loan.
- In flat rate method, the interest rate is calculated on the principal amount of the loan. On the other hand, the interest rate is calculated only on the outstanding loan amount on monthly basis in the reducing balance rate method.
- Flat interest rates are generally lower than the reducing balance rate.
- Calculating flat interest rate is easier as compared to reducing balance rate in which the calculations are quite tricky.
- 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.
- In practical terms, the reducing rate method is better than the flat rate method.
Which is Preferable?
Clearly, the Diminishing Balance Interest Rate is preferable since it is more visible and represents the “Effective Interest Rate. Flat Interest Rate is commonly utilised to attract clients with too good to refuse deals. Imagine receiving a five-year loan with a ten percent interest rate.
Sounds great, however after doing some investigation, you may find out that interest rates are set on a flat basis, and the Effective Interest Rate (also known as the Diminishing Balance Interest Rate) is really 17.27 %.