Flat Rate vs Reducing Rate: Loan Cost, EMI and Interest Comparison

The first thing that a borrower usually takes note of when comparing loan deals is the interest rate. Comparing the interest rate percentage quoted by two lenders does not always give the entire picture because the way interest is computed will affect how much you will pay back.

There are two types of interest rates usually cited: flat interest rate and reducing balance interest rate. Both could be expressed in annual terms, but they compute interest in different ways. A flat interest rate uses interest based on the initial principal for the whole term of the loan, while a reducing interest rate uses interest on the remaining balance after each repayment.

It is possible that a loan deal with a lower flat interest rate turns out to cost more than one with a higher reducing interest rate.

Key Insights

• Flat rate takes interest on the initial amount borrowed.
• The reducing rate takes interest on the remaining principal amount.
• The reducing rate is usually cheaper with the same nominal rate.
• Compare APR, EMI, tenure, fees, and overall payment.

• Check the prepayment policy before selecting your loan.

   

What is a Flat Interest Rate?

Flat interest rates are the ones that are calculated based on the initial amount borrowed throughout the tenure of the loan. As you pay EMI amounts towards the loan, the principal decreases, but the interest calculation will continue on the initial loan amount.

The basic equation is:

Total Interest = Principal * Rate * Tenure

Suppose you have taken a loan of ₹5 lakhs for five years with a flat interest rate of 10% per year.

The total interest will be:

₹5,00,000 * 10% * 5 = ₹2,50,000

Thus, the total amount will be ₹7,50,000, without including any other costs. Dividing this amount by 60 months gives an approximate EMI of ₹12,500.

The main thing here is that even though the amount borrowed is decreasing, the interest will be calculated on the initial ₹5 lakhs

Characteristics of a flat rate

• Interest is charged on the initial principal.
• The interest element does not decline due to the repayment of the principal amount.
• EMI tends to remain constant during the tenure period.
• The interest burden is usually greater than the reducing balance rate.

• The nominal rate is lower than the actual interest rate.

   

Reducing Interest Rate Explained

In a reducing balance interest rate scenario, interest is calculated on the outstanding principal balance and not on the principal loan amount.

Every EMI comprises some share for interest repayment and some share for repayment of the principal. As the outstanding principal balance reduces, the interest payable is reduced in successive months.

In case you take a loan of ₹5,00,000 at an interest rate of 10% under a reducing interest rate scheme, then the first month's interest will be calculated on the outstanding principal balance. After paying the EMI, and as the principal reduces, interest calculations will be done on the reduced principal.

Your monthly EMI would not vary considerably during your repayment tenure; however, the structure of the EMI varies.

The major chunk of the EMI in the initial period is the interest repayment share. However, gradually this part reduces while the repayment towards the principal rises.

Flat Rate vs Reducing Rate: What Is the Difference?

The easiest way to understand the difference is to compare how interest is calculated.

More closely reflects the declining loan balance

Comparison

Should be converted to an equivalent rate

Can be compared using the effective rate/APR

Which of the Two (Flat Rate or Reducing Rate) Is More Economical?

A reducing rate tends to be more economical if the nominal interest rate and the other loan parameters are the same, since the interest is calculated using the outstanding amount borrowed.

Nevertheless, one should not go by the interest rate alone. The lending institution that provides a reducing interest rate may actually have a higher interest rate quote, while another one may have a lower flat interest rate. In this case, one needs to calculate the repayment to know which loan is economical.

An interest rate of 10% on a flat basis could be considered approximately equal to an interest rate of 17% on a reducing balance basis. However, these values are approximations since the reducing balance equivalent would depend on variables like the tenure of the loan and repayment mechanism. For instance, in the case of a loan tenure of two years, the 10% flat rate could be approximately 17%, but in the case of five years, it could be 18.5%.

How to Compare Between Fixed and Reducing Rate Loans?

When comparing two loan schemes, do not just look at the interest rate.

1. Find out the total interest

Know the total interest that you have to pay throughout the entire tenure of the scheme. Lower EMI does not always mean a lower cost of a loan.

2. Compare the EMIs

Your EMI must be comfortable to repay within the budget limits. However, never pick a loan based on the basis that the EMI is lower, as it may lead to high interest payments along with a longer tenure.

3. Consider the APR

The Annual Percentage Rate (APR) gives a complete idea to compare the loan schemes, as it considers the total cost of the loan, taking into account interest and some mandatory charges.

As per the Reserve Bank of India, the lenders must provide a Key Facts Statement (KFS) for all applicable retail and MSME term loans. The document includes details such as APR and repayment schedule. 

4. Think about other charges

Do not focus on the interest rate only, and think about:

• Charges for processing
• Documentation charges
• Prepayment or foreclosure charges, if any
• Late-payment charges
• Mandatory charges

These will add to the cost of the loan you take.

5. Think about the loan tenure

The same interest rate can cause different total interest payments depending on the tenure. If the tenure is longer, then the monthly EMI will be lower, but the total interest will be higher.

Flat Rate v/s Reducing Rate: Which is the Better Choice for You?

The reducing rate can be more economical for many borrowers in comparison to loans with flat rates, as the interest gets charged on the remaining principal.

But then again, your choice must depend upon the loan structure as a whole. Before you make a decision on accepting the offer, evaluate all factors, including the total repayment amount, the EMI, the tenure, the fees, and, most importantly, the APR stated in the KFS.

Conclusion

The basic difference between flat interest and reducing interest is that flat interest is charged on the principal amount throughout, whereas reducing interest is calculated on the outstanding balance.

Thus, which loan is the cheaper one? With the same nominal rate of interest, the reducing interest rate loan would usually be more economical. However, when comparing loan offers, the wise course would be to not take into consideration just the nominal interest rate but rather the annual percentage rate, the total interest payable, EMIs, etc. This simple calculation could actually save you money.

FAQs

1. Will there be any effect of the flat interest rate on the cost of pre-closing the loan?

Yes, since under the flat interest rate method, the interest will be calculated considering the initial principal amount only. Therefore, pre-closure of the loan will not help to save as much interest as expected.

2. Will two loans with the same interest rate have the same EMI?

No, EMI will vary depending on the loan amount, tenure period, the repayment frequency, and the interest calculation method.

3. Does an additional repayment always help in cutting down the interest in the future?

In the case of a reducing balance loan, additional repayment of the principal will reduce the balance amount. Thus, it will reduce the future interest, but it depends upon the terms and conditions of the lender regarding prepayment.

4. How does the repayment period impact the cost of borrowing?

The repayment period may impact how fast the principal amount gets reduced and hence how interest accrues. Borrowers should thus ensure that the repayments are made on a monthly, bi-weekly, quarterly, or some other basis.

5. Will the interest computation formula affect the affordability of the loan?

Yes, two loans with similar EMIs may have substantially different costs due to their interest computation formulas. Relying only on the EMI would thus give an inaccurate estimate of affordability.

6. What should borrowers look for in the terms of a loan?

The borrower should look for the part that spells out the interest computation formula, repayment plan, interest rate, and prepayment terms.

7. Is a short tenure always financially beneficial for the loan?

No, because a short tenure will involve relatively higher EMIs, which could cause strain on your cash flows. The ideal tenure is the one that takes into consideration both the total borrowing cost and the EMI that suits you.

8. Could there be different terms related to prepayment in case of the same rate of interest offered by different lending institutions?

Yes, as lending institutions have different terms related to partial payment, foreclosure, minimum amount of repayment, and the associated charges.

9. Why is it important to compare the payment schedule prior to applying for a loan?

The payment schedule illustrates the way in which you will be making payments and how the balance will move along. The schedule can help you make a better estimate regarding the cost of prepayment.

10. Are there loan-related expenses that might make one lower-cost offer higher?

Yes, the expenses related to the insurance, processing, documentation, etc., may raise the cost of the loan. It is better to compare not only interest rates but also the total costs of getting a loan.