When taking a home loan, understanding flat vs reducing interest rates is crucial for making a cost-effective decision. A flat interest rate keeps your payments fixed, while a reducing rate lowers interest as you repay. Each method impacts your total repayment differently, making the right choice essential for saving money.
Let’s compare both to see which suits your needs best.
What is a Flat Rate of Interest?
A flat rate of interest is a method where the interest is calculated on the original loan amount throughout the tenure, regardless of how much has been repaid. This means your interest payments remain constant, making it easy to predict but often more expensive in the long run.
Borrowers using fixed installment loans may end up paying more compared to reducing balance methods. The method is very popular in regard to car loans, personal loans, and short-term financing.
Also Read: CRE Home Loan Interest Rates
What is Reducing Rate of Interest?
The reducing rate of interest is calculated on the outstanding loan balance, meaning interest decreases as you repay. This results in lower interest costs over time, making it more cost-effective than a flat rate.
Common in home and business loans, it helps borrowers save money while ensuring fairer repayment terms.
Also Read: Home Loan Options to Buy Independent House
Comparing Flat Vs Reducing Interest Rate
Choosing the right loan type is crucial for managing costs and financial commitments effectively.
According to the mentioned comparison table, a borrower can assess which option will suit their financial goals and repayment ability best.
| Feature | Flat Rate Interest | Reducing Rate Interest |
|---|---|---|
| Total Interest Paid | Higher, as principal remains unchanged | Lower, as interest reduces over time |
| Calculation | Interest on full principal for entire tenure | Interest recalculated on outstanding balance |
| EMI Impact | Fixed EMI throughout | EMI decreases over time |
| Best For | Auto loans, personal loans, short-term financing | Home loans, business loans, long-term financing |
Read More: Home Loan EMI Calculator With Prepayment
How Does Flat Rate and Reducing Rate of Interest Works
When considering loan options, understanding how interest calculations affect your repayments is crucial. The difference between flat and reducing interest rates significantly impacts the total cost of your loan.
Flat Interest Rate:
In this method, interest gets computed on the whole principal amount for the entire duration of the borrowing period. This means your equated monthly installments (EMIs) remain constant, but you might end up paying more in interest over time.
For example, if you take a loan of ₹1,00,000 at a flat interest rate of 10% for 5 years, the interest is calculated on the full ₹1,00,000 for the entire period, leading to higher total interest paid.
Reducing Interest Rate
Here, interest is calculated on the outstanding loan balance, which decreases as you repay the principal. Consequently, your interest burden reduces over time, potentially resulting in lower total interest paid compared to a flat rate.
For instance, with the same loan parameters as above but under a reducing interest rate of 10%, the interest is recalculated on the decreasing principal, leading to overall savings.
Which One is More Beneficial?
- Flat rate loans suit short-term financing with predictable EMIs.
- Reducing rate loans are more cost-effective for long-term commitments.
You may make an informed choice that supports your financial objectives by being aware of the subtle differences between flat vs. lowering interest rates.
Check Out: Convert Flat to Reducing Balance Interest Rate
Case Study of Flat vs. Reducing with an Example
When evaluating loan options, it’s essential to understand how different interest calculation methods impact your total repayment. Let’s explore a practical case study comparing flat and reducing interest rates.
Example: You take a loan of ₹5,00,000 for a tenure of 3 years at an annual interest rate of 10%.
Flat Interest Rate Calculation:
Interest Calculation: Interest is computed on the entire principal amount throughout the loan tenure.
Total Interest: ₹5,00,000 × 10% × 3 = ₹1,50,000
Total Repayment: Principal + Total Interest = ₹5,00,000 + ₹1,50,000 = ₹6,50,000
Monthly EMI: ₹6,50,000 ÷ 36 months ≈ ₹18,056
Reducing Interest Rate Calculation:
Interest Calculation: Interest is calculated on the outstanding loan balance, which decreases as you repay.
Monthly EMI: Using the reducing balance method, the EMI can be calculated using the formula:
EMI = [P × r × (1 + r)^n] / [(1 + r)^n – 1]
Where:
P = Principal loan amount
r = Monthly interest rate (annual rate ÷ 12)
n = Total number of EMIs
Plugging in the values:
P = ₹5,00,000
r = 10% ÷ 12 = 0.00833
n = 36
EMI ≈ ₹16,134
Total Repayment: ₹16,134 × 36 ≈ ₹5,80,824
Total Interest: ₹5,80,824 – ₹5,00,000 ≈ ₹80,824
Comparison:
Total Interest Paid:
- Flat Rate: ₹1,50,000
- Reducing Rate: ₹80,824
Monthly EMI:
- Flat Rate: ₹18,056
- Reducing Rate: ₹16,134
The reducing interest rate method lowers total interest and EMIs compared to the flat rate, making it essential to understand for informed financial decisions.
Source: Understanding the Calculation of Flat vs Reducing Rate by Economic Times
Conclusion
Choosing between flat and reduced interest rates depends on your loan type and financial goals. While flat rates keep EMIs predictable but costlier, reducing rates helps save on interest over time.
Credit Dharma simplifies the home loan process, ensuring you choose the most cost-effective option for your borrowing needs.
Frequently Asked Questions
A reducing interest loan is generally better for long-term borrowing as it lowers interest costs over time. Flat-rate loans are simpler but often costlier. The best choice depends on your financial goals, loan tenure, and repayment capacity.
You can’t directly convert a flat rate loan to a reducing rate loan. However, refinancing with a lender offering reducing interest rates can help. Use a loan calculator to compare both methods and determine potential savings before switching.
A flat rate calculates interest on the full principal amount throughout the tenure, while a reducing balance method recalculates interest on the outstanding loan amount, decreasing over time. Reducing balance loans usually result in lower total interest payments.
Flat rate loans offer predictable EMIs, making budgeting easier. They are commonly used for short-term loans, such as personal or auto loans. However, they usually result in higher interest payments compared to reducing balance loans over time.
You can calculate your EMI using an online loan calculator by entering the principal amount, interest rate, and tenure. Many banks and financial institutions also provide EMI calculators to help borrowers estimate monthly payments before applying.
To get the lowest interest rate, maintain a high credit score, compare multiple lenders, opt for a shorter tenure, and negotiate with banks. Additionally, securing loans against collateral or choosing government-backed loan schemes can help reduce interest rates.
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