What is the difference between flat interest rate and reducing balance interest rate?

flat and reducing balance interest rate
Published on: 29 August 2024

If you are looking to avail any kind of loan, the most important thing to consider is the interest rate at which you will borrow the money. There is a general perception that the higher the interest rate, the bigger the EMI you would pay. So, for anyone looking to take a loan, it is necessary to decode the complexity of interest rates so as to get the best deal on a loan.

Mostly, there are two types of interest rates – flat rate and reducing balance interest rate. These two types of interest are widely used by banks and other financial institutions to calculate the EMI a borrower needs to pay every month. If you don’t want to get misguided while securing the most suitable interest rates against a loan, understanding the difference between these two types of interest rates is necessary. Let’s get to know them below.

Flat Interest Rate

Going by its name, flat interest rates are measures of the loan value and tenure, without the principal deduction done by EMIs. In other terms, borrowers are supposed to repay the loan amount over a certain period, in the form of monthly instalments.

The interest rate is calculated on the principal loan amount. The principal amount gets progressively reduced when the borrower pays the monthly instalments over time. This makes the interest rate to go down over time.

A flat rate of interest is different from this as the applicable rate remains typically higher than the nominal rate offered at the beginning. Flat interest rate-based loan are not so popular among people as the interest rate does not reduce on the final repayment of the loan amount. The calculation of a flat interest rate can be done using the following formula:

Flat Interest Calculation

Interest Payable per Installment = (No. of Years * Principal Loan Amount * Annual Interest.) / Number of Monthly Installments.

Example: Suppose, Mr. X took a personal loan of Rs. 2,00,000 for 3 years from a bank at 16% flat interest rate.

The flat interest rate equation is:

Principal Amount (P) x Rate of Interest (R) x Loan Tenure (N) / number of installments

= 2,00,000 x 16% x 3 / 36

= Rs. 2666.6

The calculation of the EMI will be done like this:

= Principal Amount (P) / number of installments

= 2,00,000 / 36

=Rs. 5555.5

Therefore, the EMI will be:

= Rs. 2666.6 + Rs. 5555.5 = =Rs. 8222.1

Reducing Balance Interest Rate

In this type of interest rate, the rate is calculated on the basis of the leftover loan amount. The more installments are paid, the more the principal amount goes down. The primary amount left after the deduction of the principal amount will carry interest on the upcoming EMIs.

In other words, the interest rate is considered reducing or diminishing if it is calculated on the leftover principal amount. The higher number of monthly installments are made, the principal amount goes down. The principal amount remaining after deducting the principal amount already paid from the total loan amount is what will be subject to interest on the subsequent EMI.

This method is also called discounting rate system. It typically results in a lower EMI as compared to the flat interest rate system.

Reducing Balance Interest Calculation

Interest Due per Installment = Interest Rate per Installment * Remaining Loan Amount

Example: If Mr. X took a loan of 1,00,000 for 2 year at an interest rate of 12%.

The interest rate will be: Principal Amount (P) x Rate of Interest (R)x Tenure of the loan (N) / number of installments

= 100000 * 12% * 2/24

= Rs. 1000

The EMI would be:

(100000 X 12%/12) X [(1+12%/12) ^24] / [(1+12%/12) ^24-1]

= Rs. 4707

The repayment schedule is given below:

Year 1 Total Payment Interest Principal Balance
    ₹ 56,488 ₹ 9,470 ₹ 47,018 ₹ 52,982
Aug-24 4,707 1,000 3,707 96,293
Sep-24 4,707 963 3,744 92,548
Oct-24 4,707 925 3,782 88,766
Nov-24 4,707 888 3,820 84,947
Dec-24 4,707 849 3,858 81,089
Jan-25 4,707 811 3,896 77,192
Mar-25 4,707 772 3,935 73,257
Apr-25 4,707 733 3,975 69,282
May-25 4,707 693 4,015 65,268
Jun-25 4,707 653 4,055 61,213
Jul-25 4,707 612 4,095 57,118
Aug-25 4,707 571 4,136 52,982

 

  Year 2 ₹ 56,488 ₹ 3,507 ₹ 52,982 ₹ 0
Sep-25 ₹ 4,707 ₹ 530 ₹ 4,178 ₹ 48,804
Oct-25 4,707 488 4,219 44,585
Nov-25 4,707 446 4,262 40,323
Dec-25 4,707 403 4,304 36,019
Jan-26 4,707 360 4,347 31,672
Feb-26 4,707 317 4,391 27,281
Mar-26 4,707 273 4,435 22,847
Apr-26 4,707 228 4,479 18,368
May-26 4,707 184 4,524 13,844
Jun-26 4,707 138 4,569 9,275
Jul-26 4,707 93 4,615 4,661
Aug-26 4,707 47 4,661 0

  Related Post

→ Cyber Security in Banking Sector in India

→  Public Banks vs. Private Banks: Which is Right for You?

→ Things to Consider When Opening a Bank Account

The Conclusion

Though the calculation of a flat interest rate is very simple, it doesn’t mean that it enables you to save on monthly repayments. In today’s time, most banks and financial institutions use discount rates or reducing balance interest rates to calculate your EMI. However, it is recommended to consult your lender to choose the best option for your loan requirements.

 

127 Views

Categories: Banking

Tags:

Related Post

Leave a Reply

Your email address will not be published. Required fields are marked *