Lenders calculate interest accrual on their loan products in two ways, through the flat and reducing interest rate methods. Depending on the method of calculation, interest accrual on products such as a personal loan can differ.
Borrowers can check the difference between flat and reducing interest to determine which lending rate is suitable for them. Take a look at the meaning of these two types of interest calculations for a better understanding of their differences.
A flat interest rate implies a lending rate that remains unchanged throughout the loan tenor. Interest is calculated for the entire loan amount at the beginning of the loan tenor. The financial institution accordingly decides on the repayment schedule and determines EMIs payable by a borrower.
It keeps the total repayment liability fixed for a borrower and helps plan finances beforehand. Flat rates of interest effectively remain higher than reducing rates, making them less popular among borrowers.
Interest calculation under the flat rate is based on the following formula –
Interest accrual on each instalment = (Loan principal x total loan tenor x interest rate per annum) / total number of instalments
Borrowers averted to taking risks usually settle for loan repayment under the flat rate of interest calculation.
Also known as diminishing interest rate or reducing balance interest rate, interest accrual under reducing rate calculation varies depending on the outstanding loan amount.
Each EMI that a borrower pays comprises a principal and an interest component. Reducing balance interest calculation takes into account the principal amount remaining. Interest accrual is, thus, based only on the principal liability outstanding. Interest rates that lenders quote under this calculation method reflect the effective lending rates.
Reducing interest rate calculation is based on the following formula –
Interest payable for each instalment = Outstanding loan amount x interest rate applicable for each instalment
With this understanding of the two methods of interest calculation, take a look at the differences in a flat rate of interest vs the reducing rate of interest.
The following points outline the difference between fixed vs reducing interest rates -
Under flat lending rate, interest is calculated on the total principal amount sanctioned whereas interest accrual under diminishing rate is based on the outstanding loan amount.
Fixed-rate calculations result in a higher effective interest rate equivalence. Reducing rate calculation, on the other hand, reflects the effective interest rate initially.
Interest rates under the flat rate method of calculation are usually fixed at a lower percentage than diminishing interest rates.
Interest calculations under flat rate are simpler and more straightforward as against the reducing interest calculations.
These points of difference between flat and reducing interest rate outline how they can impact a borrower’s finances. Make sure to check with your lender the method of interest calculation before availing of a personal loan or any other advance.
Fixed Vs Floating Interest Rate