Reducing vs Flat Interest Rate: Know the Difference
When you take a loan, the interest rate plays a key role in how much you end up repaying. But here's what many people don’t realise: not all interest rates are calculated the same way. The two most common types are flat and reducing interest rates, and the difference between them can be quite significant. A flat rate might seem cheaper at first, but that's not always true once you understand how it’s calculated. Understanding both interest calculation methods can help you make a smarter choice and pay less interest in the long run. Let’s see how they differ.
What is Flat Interest Rate?
A flat interest rate works much like a simple interest rate. The interest is calculated on the total principal amount rather than the outstanding loan balance. This means a flat rate doesn’t reduce as you repay the loan EMI payments. Since it doesn’t take into account the reducing balance method, the overall interest paid ends up being higher.
Advantages and Disadvantages of Flat Interest Rate Loans
Understanding the advantages and disadvantages can help you make a more informed decision before choosing a loan. Let's understand them through the table below:
| Advantages | Disadvantages |
| Easy to understand; the interest rate method is easier | Interest is calculated on the total loan, not the outstanding balance, leading to higher overall interest paid |
| Predictable EMI amounts throughout the loan tenure | Flat interest rate ignores reductions in the outstanding loan balance |
| Helps in budgeting as the interest calculation methods are straightforward | Usually results in higher interest on the total principal compared to reducing interest rates |
| A flat interest rate loan is simple to compare with other loans | Doesn’t reflect the effective interest rate initially or over time |
How Does a Flat Interest Rate Work?
Flat rate calculation is based on the following mathematical formula.
Flat Interest Rate = (P × R × T)
Where,
P is the principal loan amount,
R means the rate of interest, and
T refers to the repayment period
Let’s understand a flat interest rate with an example –
Suppose you took out a Personal Loan of Rs 1,75,000 for 3 years. The lender approved a Personal Loan interest rate of 15%. In this case, the total interest you will pay is Rs 78,750.
Interest Payable = (1,75,000 × 15% × 3)
= Rs 78,750
The total amount to be repaid in this case,
Total Payable = P + (P × R × T)
= (1,75,000 + 78,750)
= Rs 2,53,750
The total EMI, in this case, would be
EMI = ( P + (P × R × T) / T*12
= (1,75,000 + 78,750) ÷ (3× 12)
= (2,53,750 ÷ 36)
= Rs 7,049
What is Reducing the Balance Interest Rate on a Loan?
A reducing interest rate on a loan is a type of financing arrangement in which the interest is calculated on the outstanding loan balance, so your interest on the outstanding principal decreases with each EMI payment. Unlike a flat interest rate, it doesn’t charge interest on the total principal, which helps you pay less interest over time.
In a reducing balance method, the interest rate can be either fixed or floating. A fixed-rate loan maintains a constant interest rate until the loan ends, while a floating-rate loan adjusts with market conditions, affecting the overall interest paid.
Advantages and Disadvantages of Reducing Interest Rate Loans
Before choosing a reduced-interest-rate loan, it’s helpful to understand its key benefits and drawbacks.
| Advantages | Disadvantages |
| You pay less interest over time compared to a flat interest rate loan | EMI amounts may vary if the rate is floating |
| Interest on the outstanding principal decreases with each EMI payment | Calculations can be more complex than a flat interest rate |
| More accurate reflection of your outstanding loan balance | Interest calculation methods may be more complex to understand |
| Can lead to lower overall interest paid for the same loan tenure | The initial effective interest rate may appear higher than a flat rate |
How Does a Reduced Interest Rate Work?
You can calculate it using the reduced interest rate formula below.
EMI = [P x R x (1+I) ^ T] ÷ [((1+I) ^ T) -1)]
Where
P is the principal loan amount,
R means the rate of interest, and
T refers to the repayment period
Illustration for a reduced rate of interest
Assume you applied for a Rs 2,00,000 used car loan with a term of 36 months. The interest rate on your loan is set at 11%. In this case, your EMI is–
EMI = [ 2,00,000 x 11% x (1 + 11%) ^ 36] ÷ [((1 + 11%) ^ 36) -1)]
EMI = Rs 6,548
Flat Interest vs Reducing Interest: Which Loan is Better?
As mentioned earlier, a reducing interest rate is generally more cost-effective than a flat interest rate. Let’s understand this with an example.
Suppose you have applied for a Rs 5,00,000 loan with a repayment term of 36 months. Your loan agreement specifies an interest rate of 19%. The table below shows how interest is calculated and the overall interest paid under both the flat interest rate and the reducing balance method.
| Parameters | Reducing Balance Interest Rate | Flat Interest Rate |
| EMI | Rs 18,095 | Rs 19,444 |
| Total Interest Payable | Rs 1,14,000 | Rs 2,00,000 |
| Total Payable | Rs 6,10,000 | Rs 7,00,000 |
Whether you go for a reduced interest rate loan, you would be able to save Rs 86,000 in interest payments.
Examples of Loan Types Using Flat vs Reducing Interest Rates
Different loan types use either a flat interest rate or a reducing interest rate, depending on how interest is calculated. Knowing which method applies can help you understand your overall interest paid and make better loan decisions.
| Flat Interest Rate Loans | Reducing Interest Rate Loans |
| Personal loans with fixed EMIs | Home loans |
| Car or two-wheeler loans | Education loans |
| Consumer durable loans | Personal loans with the reducing balance method |
| Short-term business loans | Auto loans with a reducing balance rate of interest |
Difference Between Flat Rate and Reducing Rate
You might have understood the primary difference between reducing and flat rates by now. Let's take a quick look at the significant distinctions.
| Parameters | Fixed Interest | Reducing Interest |
| Calculation | It is calculated on the original borrowing amount. | It is calculated on the outstanding loan balance. |
| Formula | (P × R × T) | [P x R x (1+I) ^ T] ÷ [((1+I) ^ T) -1)] |
| Affordability | They are costlier. | They are affordable because the interest is charged on the outstanding balance. |
| Complex | They are easier to calculate. | They use a complex formula that makes calculation time-consuming and prone to error. |
Common Misconceptions About Flat and Reducing Interest Rates
Even though flat interest rate and reducing interest rate loans are common, borrowers often have misconceptions about how interest is calculated and the overall interest paid. Understanding these myths can help you make a smarter choice.
| Misconception | Reality |
| A flat interest rate is always cheaper than a reducing interest rate | Even though EMIs look smaller, the overall interest paid is usually higher because interest is calculated on the total principal, not the outstanding loan balance |
| Reducing interest rates is confusing and not worth it | With the reducing balance method, interest on the outstanding principal decreases over time, helping you pay less interest in the long run |
| EMI remains the same under all interest calculation methods | In a reducing interest rate loan, EMI may vary if the rate is floating, reflecting changes in the interest rate |
| The effective interest rate initially is lower with flat rates | Flat rates don’t account for the decreasing loan balance, which makes the effective interest rate higher than that of a reducing interest rate over the loan period |
Conclusion
The type of interest calculation method your lender uses directly affects your EMI and overall budget. Flat interest rates might seem easier to understand, but in reality, they usually result in higher overall interest paid compared to reducing interest rate loans.
Additionally, while many lenders prefer the reducing balance method, some still offer flat interest rate loans, where interest is calculated on the total principal amount, often resulting in higher overall interest payments.
Frequently Asked Questions
What is a good Interest Coverage Ratio?
A ratio above 3 is healthy, showing earnings can comfortably cover interest expenses without straining the company’s finances.
How does a reducing interest rate work?
Interest is calculated on the outstanding loan balance and decreases with each EMI, so the overall interest paid reduces over time.
Which interest rate is better for a Personal Loan: flat or reducing?
A reducing interest rate is better, as interest on the outstanding principal decreases, helping you pay less interest.
How do I calculate EMI for flat and reducing interest rates?
Flat EMI uses the total principal and rate; reducing EMI considers the outstanding loan balance, and interest is calculated each month.
Can I convert a flat-rate loan to reduce the interest rate?
Some lenders allow conversion to a reducing interest rate, lowering overall interest paid and adjusting EMIs accordingly.
Why is reducing the interest rate more cost-effective?
The reducing balance interest rate is more cost-effective because interest is calculated on the outstanding principal, which decreases with each EMI payment.
What types of loans use flat interest rates the most?
Car, two-wheeler, and consumer durable loans commonly use flat interest rates, offering predictable EMIs despite higher overall interest paid.
How does the interest rate affect my loan repayment?
Higher interest rates increase EMIs and overall interest paid, while lower rates, especially reducing rates, help you pay less interest.
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