When applying for a loan it is essential to know how interest is calculated. There are two common methods of calculating loan interest- flat interest rate and reducing interest rate. Here’s a lowdown on what they mean and which one is more suited for you!
What is Flat Interest Rate
A flat interest rate means a lending rate that does not change through the loan tenure. It is calculated on the entire loan amount throughout the loan tenure, regardless of how much you have already repaid. In simple words, the interest is always charged on the original principal amount and not the remaining balance.
For example, if you borrow ₹1 lakh at a 10% flat interest rate for three years, the interest will be calculated on the full ₹1 lakh for all three years, even as you repay parts of the loan.
What is Reducing Interest
The reducing interest rate is calculated on the outstanding loan balance rather than the original principal. As you repay your loan, not only does the principal amount reduce, but also the interest charged is reduced.
For example, if you take a ₹1 lakh loan with a reducing interest rate of 10% for three years, the interest for the second month will be calculated on the reduced balance after the first month’s repayment. This method is commonly used for home loans, business loans, and mortgages.
Differences Between Flat Vs Reducing Interest Rate
Now that we know what flat interest rates and reducing interest rates mean, here are what makes the two different from each other:
1. Calculation Base: In a flat interest rate, the interest is charged on the full loan amount for the entire tenure while a reducing interest rate calculates interest on the outstanding loan balance.
2. Monthly Repayments: In a flat interest rate, the interest is fixed throughout the loan tenure while in reducing interest rate, as you pay off your loan, the principal reduces, and so does the interest.
3. Total Interest Paid: The total interest paid in flat interest rate is higher as compared to reducing interest rate which is lower.
4. Interest Rate Calculations: A flat interest rate is easy to calculate while a reducing interest rate is slightly more complex due to recalculations.
How to Calculate Flat Interest Rate
Here’s a flat interest rate calculation formula
Principal amount (P), Annual Interest Rate (I) – in percentage, Tenure (T) – in years
Total Interest = (P * I * T)/100
Total amount to be repaid = P + (P * I * T) /100
Monthly EMI = ( P + (P *I* T)/100) / T*12
What is Reducing Interest Rate Calculator
In a reducing interest rate method, interest is calculated on the outstanding loan balance, which decreases with each EMI payment. The formula is:
Monthly Interest = Outstanding Loan Balance × (Annual Interest Rate)/ 12
For example, suppose you borrow ₹10,00,000 with a reducing interest rate of 10% per annum (0.833% per month), and your first repayment reduces the principal by ₹50,000. In that case, the interest for the second month will be calculated on the remaining balance of ₹9,50,000.
Conclusion
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