A flat rate of interest differs from a reduced rate, so before you choose a loan, knowing which is better for you is important. Lenders offer various types of interest rates and a suitable option that can lower your borrowing costs.
Read on to understand flat vs reducing interest rates.
A flat interest rate is the rate of interest that remains unchanged through the tenure of the loan. The interest is calculated for the total loan amount at the start of the loan tenure. The financial institution determines the EMI amount and the schedule of repayment.
In this type of interest rate, the liability remains fixed, helping you manage your finances better. However, keep in mind that the total interest liability is higher for flat rates when compared to reducing rates.
Check out the formula for a flat rate of interest:
Flat interest rate = (P × R × T)/100
P is the principal loan amount
R is the interest rate in percentage
T is the repayment period
A reducing rate is a type of interest in which your interest liability reduces with every EMI payment. This is because the interest is computed on the outstanding loan amount each time you repay a portion of the loan.
Since your interest dues decrease with every instalment, this can be a more cost-effective option.
Here is the formula for reducing interest rates:
Reducing interest rate = [P x R x (1+I) ^ T] ÷ [((1+I) ^ T) -1)]
P is the principal loan amount
R is the rate of interest / (100 x 12)
T is the repayment period in years x 12
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Check out how flat and reducing interest rates differ, which can help you plan your loan terms better.
With a loan that comes with a reducing rate of interest, the interest that you need to pay is based on the outstanding loan amount. Here, the payable interest is calculated on the new principal after the payment of each EMI.
On the other hand, in a flat interest rate, the payable interest is calculated on the original loan amount at the beginning of the loan tenure.
It is comparatively easier to calculate the payable interest for flat interest rates. This is because they remain fixed throughout the duration of the loan.
The calculation of interest payable for reducing interest rates is complicated since the interest amount changes with each EMI you pay. In this case, the payable interest is calculated on the outstanding loan amount.
Reducing interest rate loans are comparatively more affordable. This is because, with each EMI payment you make, the interest liability for the loan reduces. However, this is not so in the case of flat-interest rate loans.
Now that you know how to access a flat rate vs. reducing rate, make a smart borrowing decision. A flat rate of interest is easier to understand but it can be expensive in the long run. So, research your options and choose one that suits your repayment plan while keeping the borrowing cost lower.
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Say you get a loan of ₹1 lakh for 12 months at a 10% interest rate. In a reducing balance interest rate calculation, your EMI will be ₹1,195 and the total payable interest comes to ₹72,091.
When you choose a flat interest rate, your EMI comes to ₹1,528 and the total payable interest will be ₹1,20,000. So, you stand to save ₹47,909 with a reduced interest rate calculation.
A reducing interest rate can be better than a flat rate since it frees up your income as the tenure of the loan progresses. However, flat interest rates are more commonly available and easier to calculate.