We’re discussing how banks and other financial organisations compute a loan’s interest rate. In a murky scenario like this, when no bank person would give you the exact interest rates and other details, it’s even more critical to know how to calculate this in advance. In basic terms, when you take out a loan for a specific length of time, you must repay the main amount as well as the interest within that time frame. Aside from the loan rate, it’s critical to understand how the bank will compute interest on your house loan. The flat interest rate technique and the falling balance interest rate approach are the two most prevalent ways for calculating interest on loans.
What is Flat Interest Rate?
A flat interest rate refers to a rate of interest that is determined on the full loan amount. If you apply for a business loan in India, the interest rate will remain the same throughout the duration of the loan. Flat interest rates are usually more expensive than interest rates that are being reduced.
In this case the personal loan interest rate is calculated on the initial principal amount without accounting for the principal repaid. This method of interest calculation results in a higher EMI. This can be understood better with the example below,
Let us assume you take a Rs. 1, 00,000 loans at 10% interest rate. The interest component for every year would be 10,000/-. So in case you would like to repay the loan in 3 years, the total of the principal amount and the interest rate would be Rs 1,00,000/- + Rs, 30,000/- i.e. Rs 1,30,000/- This will be divide by 3 years i.e. a total Rs 1,30,000/- divided by 36 months i.e. Rs. 3612 per year. The same in case of a reducing balance approach would be would be Rs. 3227/-. This best personal loan interest rate you can look for in the case of some private lenders for a quick loan.
Benefits of Flat Interest Rate Loans
- Tracking and calculating are simple
The calculation for a flat rate is very straightforward. Both the lender and the borrower may readily follow loan agreements made at a fixed interest rate since they are transparent. In India, all semi-financial entities provide flat MSME and corporate loan interest rates, such as village banks, self-help groups, and ASCA.
- Flat-rate loans are a good way for farmers to get the cash they need
Many borrowers in developing countries, including farmers, seek loans with balloon payments. The reason for this is that a flat rate calculation is simpler to comprehend.
- In-kind loan transactions are preferred by flat rate loans
Prior to the invention of currency, the concept of a flat rate of interest existed. It’s the most common method of repaying a loan in regular instalments.
What is Reducing Interest Rate?
A reducing rate for a personal loan calculates interest on the principal amount outstanding at the conclusion of a given term, as opposed to fixed vs. lowering rates. As you pay your EMIs, a portion of your principle is lowered, and the remainder is used to pay interest. The interest rate for the next month will change since it will be based on the new principle owed.
For example, if you obtain a loan of Rs 1,00,000 for 5 years at a lowering rate of interest of 10% p.a., your EMI cost would decrease with each payments. You would pay Rs 10,000 in interest the first year, Rs 8,000 on a decreased principle of Rs 80,000 the second year, and so on, until you only paid Rs 2,000 in interest the last year. You would pay Rs. 1.3 lakh instead of Rs. 1.5 lakh, as opposed to Rs. 1.5 lakh if you used the fixed rate option.
Benefits of Reducing Balance Loan Interest Rate
The primary benefit associated with a reducing balance interest rate is that as time passes, the applicant has to pay lesser interest compared to flat interest rate loans.
However, in the case of a flat rate, the loan will be repaid in a shorter duration, so the interest for the months that have been paid in advance need not be paid. However, in reducing interest rate, the duration of repayment and the interest component will also be impacted.
Differences between Flat Interest Rate and Reducing Interest Rate
Checkout our Flat Vs Reducing Balance Rate calculator to have a clear idea about it.
- When using the flat rate method to determine your Mudra loan interest rate or business loan interest rate, the initial principal is used to calculate the interest irrespective of the amount already paid or the balance remaining. In the case of the reducing interest rate method, the interest is calculated based on the principal outstanding or balance remaining.
- It is easy to determine the flat rate using a flat rate interest calculator, compared to the reducing interest rate.
- A reducing interest rate is better from the borrowers’ perspective compared to a flat rate as it offers the flexibility to prepay a certain portion of the loan to reduce the interest burden.
- For a fixed interest rate loan, the calculation will be based on the total amount sanctioned whereas for a reducing balance loan it will be based on the principal amount that is outstanding.
- The loan tenure of a fixed interest loan will usually be longer than that of a reducing balance loan.
- In flat rate method, the interest rate is calculated on the principal amount of the loan. On the other hand, the interest rate is calculated only on the outstanding loan amount on monthly basis in the reducing balance rate method.
- Flat interest rates are generally lower than the reducing balance rate.
- Calculating flat interest rate is easier as compared to reducing balance rate in which the calculations are quite tricky.
- Flat interest rates are usually lower than diminishing interest rates. Assume the lender will charge a 12% flat rate and an 18% reducing interest rate. However, you will end up paying more interest overall in the 12% flat rate than in the 18% reducing interest rate over the loan’s tenure.
- In practical terms, the reducing rate method is better than the flat rate method.