When you take out a loan, it’s very important to understand how the interest is calculated. Many people get confused by the terms. There are two main methods: Flat Rate Interest and Reducing Rate Interest. These terms might sound complicated, but we’ll break them down in a very simple way.
Before diving into the specifics, let's briefly understand what an interest rate is.
An interest rate is the cost of borrowing money from a lender. It is expressed as a percentage of the loan amount and is typically paid periodically, such as monthly or annually.
Interest rates show how much extra you’ll pay on top of the loan amount. The higher the rate, the more you’ll end up paying. So, it’s important to understand how interest is calculated to avoid paying too much.
Flat rate interest is a method where the interest is calculated on the entire principal loan amount throughout the loan tenure. Irrespective of how much of the loan you’ve repaid, the interest is charged on the original loan amount.
Let’s break it down with an example:
Loan Amount: ₹5,00,000
Interest Rate: 10% per annum
Loan Tenure: 5 years
With a flat rate, the interest for each year is calculated on ₹5,00,000 (the original loan amount), regardless of the amount you have repaid over the years.
Interest Calculation:
Annual Interest = (₹5,00,000) × (10/100) = ₹50,000
So, over 5 years, you would pay:
Total Interest = ₹50,000 × 5 = ₹2,50,000
Total Repayment (Principal + Interest):
₹5,00,000 + ₹2,50,000 = ₹7,50,000
Important: With flat rate interest, you pay interest on the full loan amount throughout the loan term, even if you’ve already paid back part of it.
Simplicity: Easy to calculate and understand.
Predictability: Fixed amount of interest is charged throughout the loan tenure.
Higher Interest Cost: You pay more interest compared to other methods because it doesn’t consider the decreasing principal amount.
Not Transparent: Might look cheaper in initial calculations but ends up being more expensive.
Reducing rate interest, also known as Diminishing Balance Interest or Reducing Balance Interest, is a method where the interest is calculated on the outstanding loan amount after each installment is paid. As you repay the principal, the interest for subsequent periods is calculated on the reduced balance.
Let’s use the same example but with reducing rate interest:
Loan Amount: ₹5,00,000
Interest Rate: 10% per annum
Loan Tenure: 5 years
In reducing rate interest, the interest is calculated on the outstanding loan balance, which decreases with each repayment.
Year 1: Interest = (₹5,00,000) × (10/100) = ₹50,000
Year 2: Outstanding Principal = ₹5,00,000 - (Repayment of Year 1)
Interest = (Outstanding Principal) × (10/100)
And so on...
Important: With reducing rate interest, the amount of interest you pay gets lower over time because it’s based on the remaining loan balance, not the original loan amount.
Lower Interest Cost: You end up paying less interest because the amount on which interest is calculated decreases over time.
Fair and Transparent: Accurately reflects the interest based on the outstanding loan amount.
Complexity: Slightly more complex to calculate compared to the flat rate.
Variable Interest Payment: The interest payment decreases over time, making it less predictable for budgeting.
Let’s compare the two interest calculation methods to understand their impact on your loan repayment.
| Feature | Flat Rate Interest | Reducing Rate Interest |
|---|---|---|
| Interest Calculation | On the original loan amount throughout the tenure | On the outstanding principal balance after each repayment |
| Interest Cost | Generally higher | Lower due to decreasing interest on the outstanding amount |
| Monthly Installments | Fixed (Principal + Interest) | Varies, as the interest component decreases over time |
| Transparency | Less transparent; looks cheaper but costs more | More transparent and reflects the actual cost of borrowing |
| Complexity | Simple and easy to calculate | Slightly more complex but more accurate |
| Example Scenario | Loan Amount: ₹5,00,000, Interest Rate: 10%, Tenure: 5 years | Loan Amount: ₹5,00,000, Interest Rate: 10%, Tenure: 5 years |
| Total Interest Paid | ₹2,50,000 | Approx. ₹1,37,500 (varies based on the amortization schedule) |
| Total Repayment | ₹7,50,000 | Approx. ₹6,37,500 |
Important: Reducing rate interest is often cheaper for borrowers because you pay interest only on the remaining loan balance.
Choosing between flat rate and reducing rate interest depends on several factors, including your loan amount, tenure, and financial goals. Here are some considerations to help you decide:
Reducing Rate Interest is generally more cost-effective over long tenures because the interest is charged on the diminishing balance.
Flat Rate Interest might appear lower initially but can result in a higher total interest cost over time.
For short-term loans, the difference between the two might not be significant.
For long-term loans, the reducing rate method will save you more money in the long run.
With Flat Rate Interest, you have a fixed monthly installment, which might be easier to manage if you prefer predictable payments.
With Reducing Rate Interest, your payments decrease over time, which might be beneficial if you expect your income to increase or want to save on interest costs over time.
Flat Rate Interest might be simpler and suitable if you’re looking for straightforward calculations.
Reducing Rate Interest offers a more accurate reflection of your loan costs and is better suited for those who want to minimize their interest payments.
Important: Always compare the effective interest rates (EIR) when choosing a loan. This helps you see the total cost more clearly.
| Feature | Flat Rate Interest | Reducing Rate Interest |
|---|---|---|
| Interest Calculation | On the entire principal loan amount | On the outstanding loan balance |
| Total Interest Paid | Higher due to fixed interest on the original principal | Lower due to interest on reducing balance |
| Monthly Payments | Fixed throughout the tenure | Decreases over time |
| Simplicity | Simple and easy to calculate | More complex but accurate |
| Best For | Short-term loans where simplicity is preferred | Long-term loans where total cost saving is crucial |
Choosing between flat rate and reducing rate interest affects the total cost of your loan. Flat rate interest might look simpler, but it usually means higher overall payments because interest is calculated on the full loan amount for the entire term. Reducing rate interest is fairer and cheaper because it charges interest only on the remaining loan balance.
Flat rate interest means you pay interest on the entire loan amount throughout the loan term, even if you’ve repaid part of it.
Reducing rate interest means you pay interest only on the remaining loan balance, so the interest amount decreases as you repay the loan.
With flat rate interest, you end up paying more overall because interest is calculated on the full loan amount throughout the loan period.
Reducing rate interest usually costs less because you pay interest on a decreasing loan balance, so the total interest paid is lower over time.
Typically, no. Once you choose a loan with a specific interest rate method, you have to stick with it for the term of the loan.
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