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Introduction to flat rate and reducing interest rate
When taking a loan, lenders calculate interest using two main methods: flat interest rate and reducing interest rate. Understanding flat vs reducing interest rate is essential, as the method you choose affects the total interest you will pay over the loan tenure
Understanding flat vs reducing rate of interest is important before applying for any loan. These two interest calculation methods directly affect your EMI amount and total repayment cost. In the flat interest rate method, interest is charged on the full loan amount throughout the tenure, while the reducing interest rate method calculates interest only on the remaining principal balance after each EMI payment. Since the outstanding amount keeps decreasing in the reducing balance method, borrowers usually pay lower overall interest compared to the flat rate method over the same loan tenure.
Before applying for a loan, it is important to understand the differences between these two methods. Choosing the right interest calculation—flat or reducing—can help you manage your finances better and save significantly on interest over time.
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What is a flat interest rate?
A flat interest rate is calculated on the original loan amount for the entire tenure of the loan. Under this method, the interest rate remains fixed, and interest is calculated on the full principal, regardless of the repayments made during the loan period.
How is flat interest calculated?
Interest under the flat rate method is calculated using the following formula:
Total Interest = (P × R × T) / 100
Where:
- P is the principal amount
- R represents the annual interest rate (in percentage)
- T is the loan 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 personal loan 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.
How is reducing interest rate calculated?
A reducing interest rate is calculated on the outstanding loan balance after each EMI payment. This means the interest amount decreases over time as the principal gets repaid. The interest for each instalment is calculated using the following formula:
Interest for each instalment = Outstanding loan amount × interest rate applicable for the period
Compared to a flat interest rate, a reducing interest rate usually results in lower total interest payable over the loan tenure. Understanding both calculation methods helps borrowers make informed decisions when comparing flat and reducing personal loan interest rates.
Read more: What is interest rate and how does it work?
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.
How does reducing interest work on loans?
In the reducing interest method, interest is calculated only on the remaining loan balance after each EMI payment. As the principal amount decreases over time, the interest payable also reduces gradually. This makes the reducing balance method more cost-effective compared to the flat interest method. When comparing flat and reducing interest, borrowers often find that reducing interest loans result in lower total repayment costs over the loan tenure.
Difference between flat and reducing interest rate
Understanding flat vs reducing interest rate helps borrowers compare loan costs, EMI structures, and total repayment amounts before choosing a suitable loan option.
| Basis of comparison | Flat interest rate | Reducing interest rate |
|---|---|---|
| Basis of calculation | Interest is calculated on the full loan amount throughout the tenure. | Interest is calculated only on the outstanding loan balance after each EMI payment. |
| Effective interest cost | The overall interest outflow is usually higher over the loan tenure. | The total interest payable is generally lower as the principal reduces gradually. |
| Interest rate comparison | Flat rates are usually shown at a lower percentage. | Reducing rates may appear higher initially but are often more cost-effective overall. |
| EMI impact | EMI remains fixed because interest is charged on the original principal amount. | EMI calculation changes based on the reducing outstanding balance. |
| Calculation method | Simpler and easier to calculate manually. | Slightly more complex because interest changes after every repayment. |
| Loan affordability | May increase the total repayment burden over time. | Usually helps reduce overall borrowing costs during the loan tenure. |
| Common usage | Often used in short-term consumer financing and some vehicle loans. | Commonly used for personal loans, home loans, and long-term borrowing. |
| Principal reduction effect | Repayments do not affect the interest calculation basis. | Interest decreases gradually as the principal amount reduces. |
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.
Flat vs reducing interest rate - which is better?
Choosing between a flat interest rate vs reducing interest rate depends on your financial goals and preferences. A flat interest rate stays fixed throughout the loan tenure, offering predictable monthly payments. On the other hand, a reducing interest rate decreases as your outstanding loan balance reduces, which can save you money over time. Assess your financial situation, repayment capacity, and long-term costs to decide which option suits you best.
Read more: Fixed vs floating interest rate
Key offerings: 3 loan types
Personal loan interest rate and applicable charges
Type of fee | Applicable charges |
Rate of interest per annum | 10% to 30.5% p.a. |
Processing fees | Up to 4.13% of the loan amount (inclusive of applicable taxes). |
Flexi Facility Charge | Term Loan – Not applicable Flexi Loans –Up To Rs 1,999 To Up To Rs 18,999/- (Inclusive Of Applicable Taxes) |
Bounce charges | Rs. 700 to Rs. 1,200/- per bounce “Bounce charges” shall mean charges for (i) dishonor of any payment instrument; or (ii) non-payment of instalment (s) on their respective due dates due to dishonor of payment mandate or non-registration of the payment mandate or any other reason. |
Part-prepayment charges | Full Pre-payment:
Part Pre-payment
|
Penal charge | Delay in payment of instalment(s) shall attract Penal Charge at the rate of up to 36% per annum per instalment from the respective due date until the date of receipt of the full instalment(s) amount. |
Stamp duty (as per respective state) | Payable as per state laws and deducted upfront from loan amount. |
Annual maintenance charges | Term Loan: Not applicable Flexi Term (Dropline) Loan: Up to 0.295% (Inclusive of applicable taxes) of the Dropline limit (as per the repayment schedule) on the date of levy of such charges.
Up to 0.472% (Inclusive Of Applicable Taxes) Of The Dropline Limit During Initial Tenure. Up to 0.295% (Inclusive Of Applicable Taxes) Of Dropline Limit During Subsequent Tenure |
| Credit guarantee scheme fee | Up to 1.18% p.a. (pro-rated daily till 31st March) (inclusive of all applicable taxes) of the loan amount |
| Credit guarantee scheme renewal fee | Up to 1.18% p.a. (inclusive of all applicable taxes) on the outstanding loan amount as on April 01 of the subsequent Financial Year. *Renewal Fee to be collected only for 3 subsequent financial years. **If the Remaining Tenure is less than 12 months, the CG Fee in subsequent years shall be charged prorated. |
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Overview
Methods
Interest
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.
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.
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.
Under the flat rate method, interest is calculated on the original loan amount for the entire tenure.
Formula:
Total Interest = (Principal × Interest Rate × Tenure) / 100
The total interest is then added to the principal and divided by the number of months to calculate the EMI.
Under the reducing rate method, interest is calculated on the outstanding loan balance after each EMI.
Formula (per instalment):
Interest for the period = Outstanding loan amount × interest rate applicable for the period
As you repay EMIs, the principal reduces, which lowers the interest portion over time.
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.
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.
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.
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.
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.
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.
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.
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.
Flat interest rates are commonly used in some vehicle loans, consumer durable financing, and short-term loans where interest is calculated on the original loan amount.
A flat rate is considered higher because interest is charged on the full principal amount throughout the loan tenure, even after partial repayments through EMIs.
The reducing rate method lowers the interest amount as the outstanding principal decreases, helping borrowers reduce the total repayment cost over the loan tenure.
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