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, so your repayment liability is consistent 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 calculation under the flat rate is based on the following formula:
Flat interest rate formula
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?
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 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 outstanding loan amount. Interest is calculated only on the outstanding principal liability and not the total principal borrowed. Also, effective lending rates are taken into account.
Reducing interest rate calculation is based on the following formula:
Reducing interest rate formula
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.
With this understanding of the two interest calculation methods, take a look at the difference between a flat rate of interest and a reducing rate of interest.
Difference between flat and reducing interest rate
The following points outline the difference between fixed vs reducing interest rates:
1. Basis of calculation
Under a flat lending rate, interest is calculated on the total principal amount sanctioned, whereas interest accrual under a diminishing rate is based on the outstanding loan amount.
2. Effective interest rate equivalence
Fixed-rate calculations result in a higher effective interest rate equivalence. On the other hand, reducing rate calculation reflects the effective interest rate initially.
3. Rate comparison
Under the flat rate calculation method, interest rates are usually fixed at a lower percentage than diminishing interest rates.
4. Simplicity of calculation
Interest calculations under a flat rate are more straightforward than the reducing interest calculations.
These points of difference between flat and reducing interest rates outline how they can impact a borrower’s finances.
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