Flat vs Reducing Interest Rates - Which One is Better

Q: How to calculate flat rate and reduced rate?

Flat rate : Calculate interest on the original loan amount (principal) for the entire tenure using the formula: Interest = (Principal × Rate × Tenure)/100 . Add this interest to the principal and divide by loan tenure to find the EMI. Reduced rate : Calculate interest on the outstanding principal after each repayment. Use the formula: EMI = [P × R × (1+R)^N] / [(1+R)^N – 1] , where P = principal, R = monthly interest rate, and N = number of months.

Published Apr 23, 2025 · 4 Min Read

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Introduction to Flat Rate and Reducing Interest Rate

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.

In a nutshell, the difference between flat rate and reducing rate is as follows:

Flat interest rate: In a flat interest rate method, interest is calculated on the original loan amount (principal) throughout the loan tenure, irrespective of the repayments made. For example, if you borrow Rs. 1 lakh at a flat rate of 10% for three years, the interest is always calculated on Rs. 1 lakh, resulting in higher overall interest costs.

Reducing interest rate: In this method, interest is calculated on the outstanding loan balance after each repayment. As you pay EMIs, the principal reduces, and the interest amount decreases over time. For instance, a reducing rate of 10% on Rs. 1 lakh over three years results in lower total interest compared to a flat rate, making it more cost-effective.

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.

Flat interest rate formula

Interest calculation under the flat rate is based on the following formula:

Total Interest = (P * R * T)/100

where,

P is the principal amount
R show the annual interest rate (in percentage)
T is tenure (in years)

Benefits of flat interest rate

A flat interest rate remains constant throughout the loan tenure, making it predictable and easy to calculate. Borrowers know their exact repayment amount, ensuring better financial planning. Unlike reducing rates, the interest does not decrease over time.

Key benefits:

Fixed EMI amount throughout the loan tenure.
Simple and easy-to-understand loan calculation.
Suitable for short-term loans with quick repayments.
Provides financial stability with consistent payments.

What is reducing rate of interest?

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 formula

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

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 reduced personal loan interest.

Benefits of reducing rate of interest

In a reducing interest rate system, interest is calculated on the outstanding principal, decreasing over time. This results in lower interest payments compared to a flat rate, making it cost-effective for long-term loans.

Key benefits:

Lower total interest payout over the loan tenure.
Reduces financial burden as principal decreases.
More cost-effective for long-term loans.
Encourages early repayment to save on interest.

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

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Frequently asked questions

What is interest rate?

An interest rate is the cost of borrowing money or the return on investment expressed as a percentage. It's charged by lenders to borrowers or paid by borrowers to lenders. It influences economic activity by affecting borrowing and saving decisions, impacting everything from mortgages to savings accounts and investments.

What factors influence personal loan interest rates?

Personal loan interest rates are influenced by factors such as credit score, income, loan amount, loan term, lender policies, market conditions, and the borrower's financial history. These elements collectively determine the risk associated with lending and thus affect the interest rate offered.

How to get lowest interest rate on loan?

To secure the lowest interest rate on a loan, maintain a high credit score, reduce debt-to-income ratio, shop around for lenders, negotiate terms, consider secured loans, opt for shorter loan terms, and demonstrate stable employment and income.

How to calculate flat rate and reduced rate?

Flat rate: Calculate interest on the original loan amount (principal) for the entire tenure using the formula:
Interest = (Principal × Rate × Tenure)/100.

Add this interest to the principal and divide by loan tenure to find the EMI.

Reduced rate: Calculate interest on the outstanding principal after each repayment. Use the formula:
EMI = [P × R × (1+R)^N] / [(1+R)^N – 1],
where P = principal, R = monthly interest rate, and N = number of months.

What is the difference between interest rate and flat rate?

An interest rate refers to the percentage charged on the outstanding loan balance. It can be reducing or flat, depending on the calculation method.

A flat rate assumes the same interest on the initial loan amount throughout the tenure, ignoring repayments. It typically results in higher total interest payments compared to reducing balance rates, where interest is recalculated on the decreasing principal.

Which type of interest is better?

The reducing interest rate is generally better for borrowers as it calculates interest on the outstanding balance, reducing the interest burden over time. It offers a fairer representation of the cost of borrowing. In contrast, flat interest rates may seem lower but result in higher overall costs, as they calculate interest on the full principal throughout the loan tenure. Borrowers should carefully evaluate the loan terms and repayment capacity to choose the most cost-effective option.

Is reducing interest rate good?

Yes, the reducing interest rate is advantageous for borrowers because it decreases the interest payable as the loan is repaid. Since interest is recalculated on the remaining principal after each payment, the total cost of the loan is lower compared to a flat rate. This method ensures that borrowers pay interest only on the outstanding balance, making it a more cost-efficient option, especially for long-term loans like home or personal loans.

What is an example of reducing interest rate?

Suppose you take a loan of Rs. 1 lakh at a 10% reducing interest rate for two years. The EMI is calculated on the outstanding principal after each repayment. After paying the first EMI, if Rs. 10,000 is repaid as principal, the interest for the next period will be calculated on Rs. 90,000 instead of the original Rs. 1 lakh. This ensures that your interest expense decreases over time, reducing the total cost of the loan.

Which method is easier to calculate?

The flat interest rate method is easier to calculate as it uses a straightforward formula where interest is charged on the initial principal for the entire loan tenure. In contrast, the reducing interest rate involves recalculating interest on the decreasing principal after each payment, requiring more complex mathematical formulas or financial tools, such as an EMI calculator, to determine accurate amounts.

Which method of interest rate is more profitable for borrowers?

The reducing interest rate is more profitable for borrowers as it calculates interest on the outstanding loan balance, reducing the interest cost over time. This method ensures that as the principal decreases with each EMI, the borrower pays less interest. In contrast, the flat rate method results in higher total interest payments, as it calculates interest on the original loan amount throughout the tenure.

What financial products use flat interest rates?

Financial products that often use flat interest rates include vehicle loans, personal loans, consumer durable loans, and short-term instalment loans. Lenders commonly use this method to present seemingly lower interest rates. However, borrowers should be aware that the flat rate method generally results in higher total repayment costs compared to the reducing balance method, as interest is charged on the entire loan amount for the entire tenure.

What are the alternate names for reducing interest rates?

Reducing interest rates are also known as:

Diminishing balance interest rate
Declining balance interest rate
Reducing balance interest rate

These terms highlight the method of calculating interest based on the outstanding principal balance, which decreases over time as EMIs are paid. This calculation ensures lower total interest costs compared to flat rate methods, making it a preferred choice for borrowers.

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