When it comes to borrowing money, the type of interest rate you agree to can have a big impact on how much you end up paying in total. There are two main types of interest rates: flat rate and reducing balance.

A flat rate interest rate is a constant interest rate applied to the original principal of a loan. This means that the interest rate does not change during the term of the loan, and the same interest is charged on the outstanding principal amount every month. For example, if you borrow Rs. 10,000 at a flat rate of 10% per year, you would pay Rs.1,000 in interest over the course of the year, regardless of how much of the principal you have repaid.

On the other hand, a reducing balance interest rate, also known as diminishing balance interest, is calculated on the outstanding principal amount of the loan, which reduces over time as payments are made. This means that the interest charged on the loan decreases as the outstanding principal amount decreases. For example, if you borrow Rs.10,000 at a reducing balance interest rate of 10% per year, in the first month, you would pay interest on the entire Rs.10,000. However, in the second month, you would pay interest on Rs.9,900, and so on. This way, with every payment made, the interest charged is less than the previous month’s interest.

Consider an illustration to understand better, if you borrow Rs.10,000 for a year at 10% flat rate and 10% reducing rate:

• Flat Rate Interest: With flat rate interest, you would pay Rs.1,000 in interest over the course of the year (10% of Rs.10,000), regardless of how much of the principal you have repaid.
• Reducing Balance Interest: With reducing balance interest, you would pay a total of Rs.928.43 in interest over the course of the year. This is because, with every payment, the outstanding principal amount decreases, and so does the interest charged.

From the illustration, it’s clear that the total interest paid with the reducing balance rate is less than the flat rate. This is because, over the course of the loan, the outstanding principal decreases, so the interest charged on it decreases as well.

It’s important to note that reducing balance interest is usually applied to longer-term loans, such as home loans and car loans, because it takes more time for the principal to be paid off, which makes the difference in interest more noticeable. Flat rate interest is usually applied to short-term loans, such as personal loans and credit cards, because the principal is paid off relatively quickly and the difference in interest is less noticeable.

In conclusion, the choice between flat rate and reducing balance interest rates depends on the loan type, the loan term, and the individual’s preference. Reducing balance interest rate can be beneficial in the long run as it reduces the interest paid on a loan, making the loan more affordable, but it’s important to also consider the loan term, as this would affect the difference in interest charges. It’s always advisable to have a thorough understanding of the loan terms and interest rate, consult with a financial advisor, and make an informed decision before taking on any loan. Please check our Omozing App for your personal and business money loan needs.