Lenders calculate loan interest in two 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?
A flat interest rate is calculated on the entire loan amount throughout the tenure of your loan. In this case, the interest rate or lending rate is fixed for the duration of your loan, and it will be calculated at the start of your loan tenure itself.
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 reducing interest rate?
The reducing interest rate is calculated on the diminishing principal amount. Every month when you pay your EMI, your principal loan amount decreases. And, when you opt for the reduced interest rate, the interest will be calculated only on the reduced principal amount at the time of EMI payment.
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. For better planning of your loan repayment journey, we suggest you use a personal loan EMI calculator and know your monthly EMIs in advance.
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.
Read More: What is interest rate and how does it work?
Difference between flat and reducing interest rate
Typically, lenders offer two types of interest rates to borrowers – flat interest rates and reducing interest rates. Read on to understand the difference between the two.
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.
Which is better flat or reducing interest rate?
Choosing between a flat or reducing interest rate depends on your financial goals and preferences. A flat interest rate remains constant throughout the loan tenure, providing predictable monthly payments. In contrast, a reducing interest rate decreases as the outstanding loan amount decreases, potentially saving you money over time. Consider your financial situation, repayment capabilities, and long-term cost implications to determine which option aligns better with your needs.
Read more: Fixed vs floating interest rate