Differences Between Flat and Reducing Interest Rates

Banks and NBFCs provide people with assistance to meet their financial needs. Financial help may include an MSME credit for a firm, a housing loan, a business loan or a personal loan. When applying for a loan, you can choose a fixed or lower interest rate. People may find it difficult to understand the effects of interest rate options that lead to losses and cause them to be hesitant about taking loans in the future. If you are interested in applying for a loan, it is important to understand flat interest rates and reducing interest rates, and what the difference can mean for you.

What Is a Flat Interest Rate?

A flat interest rate is a lending rate that remains constant during the loan duration. The interest is assessed for the whole loan sum at the start of the loan term. The financial firm sets the repayment plan and the EMIs due by the borrower. It also keeps your overall payback responsibility fixed and allows your finances to be organised ahead of time.

Flat interest rates are higher than reduced rates. For example, assume you borrow Rs. 100,000 at a 10% interest rate. Every year, the interest portion would be 10,000. So, if you want to return the loan in three years, the total principal amount and the interest rate would be Rs. 1,00,000 plus Rs. 30,000, or Rs. 1,30,000. This will be split into three years, resulting in a total of Rs. 1,30,000 split by 36 months or Rs. 3,612 per year.

Perks of a Flat Interest Rate 

These are the perks of a flat interest rate:

• Simple To Track and Calculate
  The flat rate formula is simple to calculate. Loan debts that are set at a fixed interest rate are clear and easy to understand for both the lender and the borrower. In India, all semi-financial groups such as village banks, self-help groups and ASCA provide fixed MSME and corporate loan rates.
• Beneficial For Farmers Many lenders in poor nations, notably farmers, want loans that permit balloon payments since a flat fee formula is easier to grasp.
• Flat-rate Loans Favour In-Kind Loan Transactions
  The notion of a flat interest rate existed before the advent of money. It is the most typical method of repaying a debt in regular installments.

What Is a Reducing Interest Rate 

In this case, a personal loan rate is calculated based on the principal outstanding amount at the end of a given period. As previously indicated, a part of each EMI paid goes toward the principal, with the rest going to the interest. The following interest calculation is based on the outstanding principal balance rather than the initial principal amount.

For example, if you obtain a loan of Rs. 1,000,000 with a reducing interest rate of 10% p.a. for five years, your EMI will decrease with each payment. In the first year, you will pay Rs. 10,000 in interest; in the second year, you will pay Rs. 8,000 on a reduced principle of Rs 80,000 and so on until you pay Rs. 2,000 in interest in the final year. In contrast to the fixed rate strategy, you will end up paying Rs. 130,000 lakh rather than Rs. 150,000.

This approach is especially useful for figuring out the interest due on housing, mortgage and property loans, as well as overdraft and credit card facilities. You must only pay interest on the unpaid loan amount using this method. The effective rate of interest offered for such loans is the same as the rate utilised for fixed deposits and savings accounts.

Perks of a Reducing Interest Rate

The main benefit of a reducing interest rate loan is that you must pay less interest over time than a flat interest rate loan. The following are additional perks:

• Interest Rate ReductionOne factor in choosing a reducing interest rate is that the principal amount drops rapidly, lowering the interest payable on the loan.
• Loan Amount
  The total cost of the loan is cheaper when using the reducing interest rate method.

Key Differences Between a Flat Interest Rate and a Reducing Interest Rate

Category	Reducing Interest Rate	Flat Interest Rate
Interest Responsibility	Lower than the interest paid under the flat interest rate system.	Higher than the interest rate paid under the reducing interest rate system.
The Basis for Calculating Interest	Based on the whole sum of unpaid principal.	Based on the total amount of principal.
Calculation Complexity Level	Compared to a flat interest rate plan, it is harder to compute.	It is easy to compute than the diminishing balance system.
Utilisation	People who live in cities favour the reducing balance interest rate plan since the total interest duty is lower than the interest rate due under the flat interest rate system.	Farmers like the flat rate interest rate plan because it is easy to compute and grasp.

Flat and Reducing Rate of Interest Calculators

The following are the flat and reducing rate of interest calculators:

Flat Interest Rate Calculators 

In flat-rate loans, interest is based on the original principal amount throughout the loan term.

Formula:

• Principal (P)
• Annual Interest Rate (I) – expressed as a percentage
• Tenure (T) is measured in years
• (P I T)/100 = Total Interest
• Total repayment amount = P + (P I T) /100
• Monthly EMI = ( P + (P I T)/100) / T*12 (T is in years)

Reducing Interest Rate Calculators 

In reducing balance rate loans, interest is computed on the remaining principal amount at any time.

Formula: 

EMI = [P x Ix (1+I) T]/ [((1+I) T)-1)]

Where:

• P denotes the main amount
• I is the interest rate / (100×12)
• T equals the number of years multiplied by 12
• Total rate equals monthly EMI multiplied by T – P
• Total amount equals monthly EMI multiplied by T

To use a flat and reducing rate of interest calculator, you can easily enter the required loan data into the calculator and get started. Here are the steps to use the flat and reducing rate of interest calculator:

• Step 1: On the calculator, enter the principal amount of the loan
• Step 2: Enter the agreed-upon tenure and interest rate details
• Step 3: Click ‘calculate’ to find out the sum of interest you will pay on the loan you have taken.

Conclusion

Reduced rates and the ease of calculation associated with flat rates may not be as advantageous as first believed. Experts believe that, although flat rates are straightforward to comprehend, they may not be as accurate when it comes to repaying large loans. As a consequence, before taking out a loan, compare the interest rates for both options using a flat and reducing rate of interest calculator. Based on this, make an educated decision. Be sure to visit Piramal Finance for more information and informative articles.