What is the Difference Between Flat vs. Reducing Interest Rates ?

If you’re looking to secure a loan, it's important to understand the different types of interest rates you may encounter. Two common terms you may come across are flat rate and reducing rate . These terms represent the different methods for calculating interest on loans, and examining their differences can help you save money and make informed financial decisions.

What is a Flat Rate ?

A flat rate (also known as a fixed rate) is a straightforward method for calculating interest on a loan. With a flat rate, the interest is calculated based on the entire principal amount throughout the loan's tenure. In other words, you pay a fixed percentage of the initial loan amount as interest throughout the loan's term. The interest amount remains constant and doesn't decrease over time, regardless of how much of the principal amount you've repaid.

How to Calculate Flat Rate Interest ?

The formula for determining the interest is:

Interest = (P x I x T)/100

Where:

• P is the principal amount.


• I is the annual interest rate (expressed as a percentage).


• T is the loan tenure in years.

Let's look at a simple example to understand how a flat rate works. Suppose you borrow ₹1,00,000 at a flat interest rate of 10% for five years. Using the formula:

Total Interest = ₹1,00,000 x 0.10 x 5 = ₹50,000

Total amount to repay = P + (P x I x T) /100 = ₹1,50,000.

So, with a flat rate, you'd pay ₹50,000 in interest over five years, regardless of how much of the principal you've repaid during this time.

What is a Reducing Rate ?

A reducing rate is a more dynamic way of calculating interest on a loan. This method takes into account the decreasing outstanding balance of the principal amount as you make periodic payments. As you repay your loan, the interest is calculated on the remaining balance, which reduces over time.

Reducing rate loans are also commonly known as "diminishing balance loans". They are the more popular choice for most loans, such as mortgages, car loans, and personal loans, as they often result in lower overall interest payments.

How to Calculate Reducing Rate Interest ?

The formula for calculating interest with a reducing rate is more complex than the flat rate method.

The basic structure of the formula is:

Interest = P x r x [(1 + r)ⁿ / ((1 + r)ⁿ - 1)] - P

Where:

• P is the principal amount.


• r is the monthly interest rate (annual rate divided by 12 and expressed as a decimal).


• n is the total number of payments (loan tenure in months).

As you make payments, the outstanding principal balance decreases, and the interest for each subsequent month is calculated on this reduced balance.

Here’s an example: Suppose you borrow ₹10,000 at a reducing interest rate of 10% for five years. Using the formula, you can determine your monthly EMI, which accounts for both principal and interest. In this case, your monthly EMI would be approximately ₹212.47. Over the course of five years, you'll end up paying ₹12,748.20 in total, which includes ₹2,748.20 in interest.

Flat Rate vs. Reducing Rate: Which is Better ?

You should consider your individual circumstances and financial goals before choosing a flat rate or reducing rate loan. But here are some points to consider:

• Flat rate loans are easier to understand and calculate. It may be more beneficial for borrowers with short-term loans. However, they typically have higher total interest payments and may be less affordable for some borrowers.


• Reducing rate loans have lower total interest payments and EMIs that become more affordable over time. Borrowers can also repay their loans early without penalty. However, reducing rate loans can be more complex to understand and calculate, and may be more beneficial for borrowers with long-term loans.


• If you plan to repay your loan early, a reducing interest rate may be a better option. This is because you will only pay interest on the outstanding principal balance of your loan.


• You must compare offers from different lenders and choose a loan that is best for you.

How to Use a Flat vs. Reducing Rate Calculator ?

Step 1: Enter the principal loan amount

Step 2: Enter the rate of interest (%) on the loan

Step 3: Enter the loan tenure (in years)

The calculator swiftly computes the total interest payment for both loan types!

In conclusion, understanding the difference between flat rate and reducing rate loans is crucial when taking out a loan. Reducing rate loans are generally more advantageous for borrowers, as they result in lower overall interest payments and offer a clear repayment structure!