What is the difference between flat and reducing interest rate?

2 min read

Lenders calculate loan interest in 2 ways: flat interest rate and reducing interest rate. Both methods of calculation result in a different interest amount payable by you, the borrower.

Before you apply for a loan, understand what the two methods are and how they vary.

What is a flat interest rate?

In this scenario, the interest rate stays constant throughout the loan tenor. The advantage is that the interest is fixed, and so your repayment liability is constant throughout the repayment term. As a result, you can plan for repayment beforehand. That said, in this method the interest rate is set marginally higher than the reducing interest rate method. Therefore, on the whole, the cost born by you is slightly higher.

Interest accrual on each instalment = (Loan principal x total loan tenor x interest rate per annum) / total number of instalments

What is a reducing interest rate?

Each EMI you pay comprises an interest and principal component. Therefore each EMI paid lowers the outstanding principal balance. In this method, the interest calculation depends on the loan amount that is outstanding. Interest is calculated only on the outstanding principal liability and not the total principal borrowed. Also, effective lending rates are taken into account.

Interest payable for each instalment = Outstanding loan amount x interest rate applicable for each instalment

As a thumb rule, if you prefer simple calculation and are risk averse, pick a loan with a flat interest rate.

Now that you know how interest rate calculation can impact your finances, check the method of calculation with your lender before availing of a personal loan.

Read more: Fixed vs floating interest rate

Read More Read Less