Personal Loan Flat and Reducing Interest Rate
Interest refers to the amount that the borrower pays over and above the certain principal amount that was borrowed. Loan interest rates are almost always calculated in the same way by the majority of banks and this rate is often called the percentage of the loan which is also referred to as annual percentage rate (APR).
Each EMI (Equated Monthly Installments) carries two aspects; one for the principal and the other for the interest. At the initial stage of the loan, a higher percentage of the EMI goes to the interest, or the interest component diminishing as progress with the EMIs with time.
In contrast, the EMI part directed to the principal is small towards the beginning but grows as the loan period progresses. In lending institutions, interest may be calculated using different strategies, and the strategy adopted affects the cost that the borrower finally pays on the personal loan.
One of the critical elements in the process is how the interest, which may be charged, is based on either the original sum borrowed or on the amount still owed. This gives rise to the concept of flat rate of interest and reducing balance rate of interest which is described further.
Personal Loan Flat Interest Rate
As the name implies, the interest rate is calculated on the full amount of the loan throughout its tenure. The effective interest rate is higher than the nominal flat rate that is usually quoted in the beginning.
For Example, Madhuri was offered a personal loan at 10% interest and the other banks that she had inquired with were offering her interest between 14-16%. She was pleasantly surprised. She started asking around and finally met with a chartered accountant friend of hers who asked her if the interest rate was calculated on a flat or a reducing balance method. On checking with the bank she found out that the interest rate was calculated on the flat interest rate method. If she would've taken a loan of Rs.5 lakhs for 5 years, she would be paying Rs.2,50,000 towards interest. Her EMI would be Rs.12,500. The interest paid in the first month and interest paid on the last month will not change and it will remain the same at Rs.4,167.
Most often the banks will follow this method of calculating Interest for Personal Loans. The interest is to be paid on the entire loan amount throughout the tenure.
Personal Loan Reducing/Diminishing Interest Rate
The interest in reducing interest rate method is calculated on the outstanding loan amount every month. The EMI includes the interest payable on the outstanding loan amount.
For Example if Madhuri had taken the loan of Rs.5 lakhs for 5 years on a 16% diminishing interest rate, she would've spent Rs.2,29,542 towards total interest. Her monthly EMI would be Rs.12,159. The interest paid in the first month would be Rs.6,593. The last month interest rate that is to be paid would be Rs.160.
- In the flat interest rate method, the interest is calculated on the principal loan amount.
- The interest on the diminishing interest rate method is calculated on the outstanding loan amount.
- Flat interest rates are lower than that of the reducing balance rate.
- The interest rate calculation for flat interest rate is easier than that of reducing interest rate.
- But, in practical terms, the reducing or the diminishing interest rate method is better as you will not be spending more towards the interest.
Madhuri realised that she was subject to mis-selling where the sales executive is withholding half information and is not being entirely clear about the interest rate calculation. She rejected the offer and instead chose a lender that was offering her a reducing interest rate and when she used the online interest rate calculators she realised that though she will be charged a higher rate of interest, she was saving some money.
Always look for the documents and then go ahead with the deal. All that is shown in a rosy hue is not always the best thing, there is a catch. If you are unaware of the financial products, then approach a person who can help with that regard. Don't fall prey to the sales gimmick of the sale executives. Compare the offers and make use of the free online interest rate calculators and only when all your queries are answered, go ahead with the offer.
Differences Between Flat and Reducing Interest Rates
Here are the main differences:
- Interest is computed on the outstanding loan amount using the declining balance method, and this amount is smaller with each installment. On the entire principal amount that was first approved, a flat interest rate is computed.
- When compared to decreasing balance rates, flat interest rates are frequently higher and are typically set at a fixed percentage.
- Lower rates over time indicate a lower effective interest rate, but flat interest computations lead to higher total interest payments.
- It is easier to calculate a flat interest rate than a decreasing balance rate.
What is a Flat Interest Rate Calculator and How Does It Work?
In loans with a flat interest rate, interest is calculated based on the initial principal amount throughout the entire loan period.
Calculation Formula:
- Principal (P)
- Annual Interest Rate (I) – in percentage
- Tenure (T) – in years
Total Interest = (P * I * T) / 100
Total Amount to be Repaid = P + (P * I * T) / 100
Monthly EMI = (P + (P * I * T) / 100) / (T * 12)
How Does It Work?
In loans with a reducing balance interest rate, interest is calculated based on the remaining principal balance at any given time.
Calculation Formula:
EMI = [P x I x (1 + I)^T] / [(1 + I)^T – 1]
Where:
- P is the principal amount
- I is the interest rate / (100 × 12)
- T is the tenure (in months)
Total Interest = (Monthly EMI x T) – P
Total Amount = Monthly EMI x T
Flat vs Reducing Rate Calculator
You can compare the two interest calculation techniques and select the best option for your loan by using the Flat vs. Reducing Rate Calculator. A detailed analysis of the interest paid on your EMIs is also provided.
How to Use Flat Rate vs Reducing Rate Calculator
Using a flat vs reducing rate calculator is simple:
1. Enter the principal loan amount.
2. Input the loan tenure and the agreed interest rate.
3. Click ‘Calculate’ to instantly see the interest payable on your loan.
Benefits of Using the Flat vs Reducing Interest Rate Calculator
- Easy-to-access online tool, available anytime and anywhere.
- Provides interest calculations within seconds.
- Saves time and effort compared to manual calculations.
- Helps assess the total loan outflow.
- Enables easy loan planning by using basic loan details.
- Allows you to compare both interest calculation methods and understand the difference in interest payments.
FAQs on Personal Loan Flat and Reducing Interest Rate
- What is the difference between a flat interest rate and a reducing interest rate?
A flat interest rate charges interest on the entire principal amount throughout the loan tenure, while a reducing interest rate calculates interest on the outstanding balance, reducing over time.
- How does a reducing interest rate benefit borrowers?
A reducing interest rate ensures lower interest payments as the outstanding principal decreases, leading to a reduced overall loan cost.
- What factors determine whether a flat or reducing rate is better for my personal loan?
Factors include the loan amount, tenure, EMI affordability, and total interest paid over time.
- Which type of interest rate results in lower EMI payments for a personal loan?
Typically, reducing interest rates result in lower EMIs over time because the interest is calculated on the decreasing outstanding balance
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