When considering a home loan, understanding the interest rate structure is crucial, as it significantly impacts the total cost of borrowing. Two primary methods used by lenders to calculate interest are the Flat Rate of Interest and the Reducing Rate of Interest. This blog explains how the reducing rate of interest works and compares it to the flat rate.
What is a Reducing Rate of Interest?
A reducing rate of interest, also known as the Reducing Balance Method, calculates interest on the outstanding principal balance of the loan. As you repay the loan, the principal decreases, leading to a reduction in the interest charged over time.
How a Reducing Rate of Interest Works?
- Interest is charged on the remaining loan balance, not the full loan amount.
- As you repay the principal, the outstanding balance reduces, lowering interest payments.
- You pay less total interest over time compared to a flat rate.
- Initially, more of your EMI goes toward interest, but later, more goes toward the principal.
Also Read: CRE Home Loan Interest Rates
Difference Between Reducing and Flat Rate of Interest for Home Loans
A reducing rate applies interest on the remaining loan balance, while a flat rate charges interest on the entire principal throughout the tenure.
Parameter | Reducing Rate of Interest | Flat Rate of Interest |
---|---|---|
Loan Amount | ₹50,00,000 | ₹50,00,000 |
Interest Rate | 8.5% p.a. | 8.5% p.a. |
Loan Tenure | 20 years | 20 years |
EMI Amount | ₹43,391 | ₹56,250 |
Total Interest Paid | ₹54,13,879 (approx.) | ₹85,00,000 |
Total Repayment Amount | ₹1,04,13,879 (Loan + Interest) | ₹1,35,00,000 (Loan + Interest) |
Interest Calculation | On the outstanding loan balance, which decreases over time. | On the entire loan amount throughout the loan tenure. |
Interest Reduces Over Time | Yes, as the principal reduces with each EMI. | No, interest remains the same throughout the tenure. |
Cost-effectiveness | More cost-effective, as interest reduces over time. | More expensive, as interest is calculated on the full amount. |
Best For | Long-term loans, like home loans. | Short-term loans or personal loans. |
Example Analysis:
- With a reducing rate, you pay ₹54,13,879 in interest over 20 years.
- With a flat rate, you pay ₹85,00,000 in interest, making it significantly more expensive.
- Thus, reducing rate loans are more economical for home loans.
Also Read: Flat Interest Rate vs Reducing Interest Rate
Pros and Cons of Reducing Rate of Interest for Home Loans
reducing rate of interest for home loans offers lower overall interest payments but may come with higher initial EMIs and more complex calculations.
Aspect | Pros | Cons |
---|---|---|
Interest Payment | Interest decreases as you repay the principal, reducing the total interest outgo. | Higher initial EMIs compared to flat rate loans. |
Cost-Effectiveness | More cost-effective for long-term loans. | Interest rates may fluctuate with market conditions. |
Loan Amount | Suitable for large loan amounts due to lower overall interest. | May have higher processing fees. |
EMI Payment | Gradually lower EMIs make loan repayment easier over time. | Not suitable for short-term loans. |
Prepayment Benefits | Better for borrowers aiming to prepay or foreclose the loan. | Complex interest calculation process. |
Read More: Home Loan EMI Calculator With Prepayment
Which Interest Rate is Better for Home Loans?
Choosing between a reducing rate of interest and a flat rate of interest for home loans depends on your preference for lower total interest payments or predictable EMIs.
Interest Rate Type | Reducing Rate of Interest | Flat Rate of Interest |
---|---|---|
Interest Calculation | Calculated on the reducing principal, resulting in lower interest over time. | Calculated on the full loan amount throughout the tenure. |
EMI Structure | Varies over time as the principal reduces. | Fixed EMI amount for the entire loan tenure. |
Total Interest Paid | Lower overall interest paid due to decreasing principal. | Higher total interest paid as interest is calculated on the full loan. |
Simplicity | More complex due to varying interest components. | Simple and easy to understand. |
Best for | Borrowers looking to minimize total interest over time. | Borrowers who prefer predictable monthly payments. |
- Choose reducing rates for long-term home loans to save on overall interest.
- Opt for flat rates if you prefer fixed EMIs for short-term loans.
Check Out: Convert Flat to Reducing Balance Interest Rate
Considerations Before Choosing a Reducing Rate of Interest
Before choosing a reducing rate of interest, it’s important to consider the impact on your monthly payments, total interest, and loan tenure.
- EMI Variability: Monthly payments will change as the principal reduces.
- Loan Tenure: Longer tenures may result in more savings due to reduced interest over time.
- Prepayment Flexibility: Making prepayments can reduce the principal and lower interest costs.
- Complexity: Understanding the varying interest components may require more effort.
- Early Repayment: The earlier you repay, the more you save on interest.
- Interest Rate Changes: Ensure your lender adjusts the interest rate if market conditions change.
Also Read: Home Loan Options to Buy Independent House
How to Calculate Home Loan EMI with a Reducing Rate of Interest
Home loan EMI with a reducing rate of interest is calculated based on the outstanding loan balance, leading to lower interest payments over time.
Loan Details:
- Loan Amount: ₹20,00,000
- Annual Interest Rate: 10%
- Loan Tenure: 20 years (240 months)
Step-by-Step EMI Calculation:
Month | EMI | Interest | Principal Repayment | Outstanding Principal |
---|---|---|---|---|
Month 1 | ₹19,292.53 | ₹16,666.67 | ₹2,625.86 | ₹19,97,374.14 |
Month 2 | ₹19,292.53 | ₹16,647.89 | ₹2,644.64 | ₹19,94,729.27 |
Month 3 | ₹19,292.53 | ₹16,628.94 | ₹2,663.59 | ₹19,92,065.68 |
Key Points:
- Interest is calculated on the reducing principal balance each month.
- First EMI: ₹19,292.53, with ₹16,666.67 going toward interest and ₹2,625.86 toward principal.
- Principal decreases each month, reducing the interest component in subsequent EMIs.
This shows how the reducing rate method leads to decreasing interest payments over time, with more of the EMI going toward the principal.
Also Read: Flat Interest Rate for Home Loans
Tips to Save More with a Reducing Rate of Interest
There are some tips to save more with a reducing rate of interest on your home loan:
- Make Prepayments: Regularly making prepayments will reduce the principal, leading to lower interest costs in the long run.
- Opt for a Shorter Tenure: A shorter loan tenure reduces the total interest paid, even if the EMI is higher.
- Pay Higher EMIs: If you can afford it, paying more than the EMI amount reduces the principal faster and saves on interest.
- Consider Refinancing: If market rates drop, consider refinancing your loan to take advantage of lower interest rates.
- Avoid Late Payments: Ensure timely payments to avoid late payment charges, which increase the overall loan cost.
By following these strategies, you can minimize the interest paid over the loan tenure and save money.
Does Lower Interest Rate Reduce Home Loan Tenure?
Yes,a lower interest rate can reduce your home loan tenure if you maintain the same EMI amount, as it allows more of your payment to go toward reducing the principal.
- Faster Loan Repayment: With lower interest, the principal reduces quicker, shortening the loan tenure.
- Lower Total Interest: A reduced interest rate means you pay less interest over the loan tenure.
- Fixed EMI: Keeping your EMI constant while the interest rate drops accelerates repayment.
- Recalculate Loan Tenure: If you choose to lower your EMI instead of maintaining the same amount, the tenure will remain the same, but the interest burden will reduce.
Source: Understanding the Calculation of Flat vs Reducing Rate by Economic Times
How to Change Your Home Loan Rate After RBI Cuts Repo Rate?
After the RBI cuts the repo rate, you can request your lender to revise your home loan rate to reflect the new lower rate.
- Monitor Rate Cuts: Keep an eye on RBI repo rate changes and announcements from your lender.
- Contact Your Lender: Reach out to your bank or lender to request an interest rate reduction.
- Submit a Request: Submit the necessary forms or documentation required by your lender to revise the rate.
- Review New Terms: Ensure that the revised rate applies to both the EMI and tenure as per your agreement.
- Refinance Option: If the lender doesn’t adjust the rate, consider refinancing with another lender offering lower rates.
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Conclusion
The reducing rate of interest for home loans offers a more cost-effective way to repay your loan by lowering interest as you reduce the principal. Make sure to choose the right plan to save on interest over time.
For the best home loan options and to understand how a reducing rate of interest can benefit you, visit Credit Dharma today!
Frequently Asked Questions
A reducing interest rate calculates interest on the remaining loan balance, which decreases over time, leading to lower total interest paid as you repay the principal.
Yes, a reducing rate of interest is better for long-term loans as it leads to lower total interest payments over time compared to a flat rate.
A floating interest rate changes based on market conditions, such as the RBI repo rate, while a reducing interest rate is calculated on the remaining principal, decreasing as you repay the loan, leading to lower interest payments over time.
A reducing rate home loan is generally better as it results in lower total interest paid overtime, as interest is calculated on the remaining loan balance. A flat rate home loan has higher interest costs, as interest is calculated on the full loan amount throughout the tenure.
To reduce interest rates, consider improving your credit score, choosing a shorter loan tenure, making larger down payments, making regular prepayments, comparing rates from different lenders, and negotiating with your current lender.
Yes, reducing interest rates are good as they help lower the total interest paid overtime, especially when the interest is calculated on the remaining loan balance, leading to more savings.