What is the difference between flat interest rate and reducing balance interest rate?

If you are looking to avail any kind of loan, the most important thing to consider is the interest rate at which you will borrow the money. There is a general perception that the higher the interest rate, the bigger the EMI you would pay. So, for anyone looking to take a loan, it is necessary to decode the complexity of interest rates so as to get the best deal on a loan.

Mostly, there are two types of interest rates – flat rate and reducing balance interest rate. These two types of interest are widely used by banks and other financial institutions to calculate the EMI a borrower needs to pay every month. If you don’t want to get misguided while securing the most suitable interest rates against a loan, understanding the difference between these two types of interest rates is necessary. Let’s get to know them below.

Flat Interest Rate

Going by its name, flat interest rates are measures of the loan value and tenure, without the principal deduction done by EMIs. In other terms, borrowers are supposed to repay the loan amount over a certain period, in the form of monthly instalments.

The interest rate is calculated on the principal loan amount. The principal amount gets progressively reduced when the borrower pays the monthly instalments over time. This makes the interest rate to go down over time.

A flat rate of interest is different from this as the applicable rate remains typically higher than the nominal rate offered at the beginning. Flat interest rate-based loan are not so popular among people as the interest rate does not reduce on the final repayment of the loan amount. The calculation of a flat interest rate can be done using the following formula:

Flat Interest Calculation

Interest Payable per Installment = (No. of Years * Principal Loan Amount * Annual Interest.) / Number of Monthly Installments.

Example: Suppose, Mr. X took a personal loan of Rs. 2,00,000 for 3 years from a bank at 16% flat interest rate.

The flat interest rate equation is:

Principal Amount (P) x Rate of Interest (R) x Loan Tenure (N) / number of installments

= 2,00,000 x 16% x 3 / 36

= Rs. 2666.6

The calculation of the EMI will be done like this:

= Principal Amount (P) / number of installments

= 2,00,000 / 36

=Rs. 5555.5

Therefore, the EMI will be:

= Rs. 2666.6 + Rs. 5555.5 = =Rs. 8222.1

Reducing Balance Interest Rate

In this type of interest rate, the rate is calculated on the basis of the leftover loan amount. The more installments are paid, the more the principal amount goes down. The primary amount left after the deduction of the principal amount will carry interest on the upcoming EMIs.

In other words, the interest rate is considered reducing or diminishing if it is calculated on the leftover principal amount. The higher number of monthly installments are made, the principal amount goes down. The principal amount remaining after deducting the principal amount already paid from the total loan amount is what will be subject to interest on the subsequent EMI.

This method is also called discounting rate system. It typically results in a lower EMI as compared to the flat interest rate system.

Reducing Balance Interest Calculation

Interest Due per Installment = Interest Rate per Installment * Remaining Loan Amount

Example: If Mr. X took a loan of 1,00,000 for 2 year at an interest rate of 12%.

The interest rate will be: Principal Amount (P) x Rate of Interest (R)x Tenure of the loan (N) / number of installments

= 100000 * 12% * 2/24

= Rs. 1000

The EMI would be:

(100000 X 12%/12) X [(1+12%/12) ^24] / [(1+12%/12) ^24-1]

= Rs. 4707

The repayment schedule is given below:

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The Conclusion

Though the calculation of a flat interest rate is very simple, it doesn’t mean that it enables you to save on monthly repayments. In today’s time, most banks and financial institutions use discount rates or reducing balance interest rates to calculate your EMI. However, it is recommended to consult your lender to choose the best option for your loan requirements.