Reducing vs Flat Interest Rate: Know the difference

Understanding your loan agreement and its clauses requires meticulous effort. You must check various parameters like loan amount, additional charges, EMI and foreclosure provisions. But it is the interest rate that deserves your special attention. There are different types of interest rates that the lender might levy on your loan. So, in addition to checking the interest rate you must also understand the type of interest rate and its impact on your loan.
 
The most common types of interest rates on a loan are flat interest rate and reducing interest rate. Read on to understand these interest rates in details.
 

What is the flat interest rate?

 
A flat interest rate is comparable to a simple interest rate. The rate is calculated on the total principal amount rather than the outstanding loan balance. A flat rate disregards periodic EMI payments and a reduction in the debt amount. Therefore, their total interest payable is a little higher.
 

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 flat interest rate with an example –
 
Suppose you took out a personal loan of Rs 1,75,000 for 3 years. The lender approves this loan at a 15% interest rate. In this case, the total amount of interest you will be paying 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 rate on a loan is a type of financing arrangement in which your interest liability decreases with each EMI payment. It calculates interest on the outstanding loan balance rather than the original borrowing amount.
 
In the context of a loan, the reducing balance interest rate can be further classified as fixed or floating. The former remains unchanged till the loan conclusion, whereas the latter fluctuates according to market conditions.
 

How does a reducing interest rate work?

You can calculate it by applying the reducing interest rate formula outlined 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 reducing 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 Rate vs Reducing Rate: Which is better?

 
As previously mentioned, a reducing rate is cost-effective. Now, let's understand this with an example. 
 
Assume you have applied for a Rs 1,000,000 two-wheeler loan with a repayment term of 36 months. Your loan agreement specifies an interest rate of 8%. The table below shows the interest liability on both fixed and reducing rates.
 

Parameters	Reducing Balance Interest Rate	Flat Interest Rate
EMI	Rs 3,134	Rs 3,444
Total Interest Payable	Rs 12,811	Rs 24,000
Total Payable	Rs 1,12,811	Rs 1,24,000

 
If you opt for a reducing interest rate loan, you would be able to save Rs 11,189 in interest payment. 
 

Difference between flat rate and reducing rate

You might have understood the primary distinction between reducing and flat rates by now. Let's take a quick look at the major 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 rate is levied on the balance dues.
Complex	They are easier to calculate.	They use a complex formula that makes calculation time-consuming and prone to error.

 
Also Read: How to calculate your personal loan EMI using Excel?
 

To conclude

The type of interest calculation your lender uses has a direct impact on your EMI and budget. Flat rates might appear to be easy to understand, but in practice, they are much more expensive than reducing balance rates. Furthermore, you will hardly find any lender on the market offering flat rates.