Flat rate vs reducing balance method: Learn how bank loans work

The Indian financial market is home to a number of private and public banks that offer a wide range of loans, like housing loans, personal loans, car loans and more. Bank loans are excellent sources of financing in case you need funding to meet various life goals, like buying or building a new home, paying for your child’s education or even paying off existing debts. Loans can also be useful when you need to pay for a financial emergency, such as a steep medical bill or an unexpected home repair.

No matter what kind of bank loan you apply for, it is essential to learn how they work. Bank loans today can typically be one of two types, depending on the kind of interest rates they come with. These two kinds of interest rate calculation are as follows:

• The flat rate method
• The reducing balance method

Let’s take a closer look at each of these methods to better understand how bank loans work.

The flat rate method

The flat rate method, as the name indicates, is where interest is calculated on the entire principal amount borrowed — at a fixed rate. The lending rate remains the same throughout the tenure of the loan. Here, the monthly EMI or Equated Monthly Installment is calculated using the formula given below.

Here, P is the principal, I is the annual rate of interest, and T is the repayment tenure in years.

The advantages of the flat rate method

Choosing the flat rate method of interest calculator for a bank comes with its own advantages. Here are some of the top reasons to opt for this method.

• Easy EMI calculation and tracking

In the flat rate method, it is easier to compute the EMIs because the interest rate is fixed throughout the tenure. All you need to do is apply it on the principal amount to compute the EMIs.

• More effective financial planning

Since the EMIs are easy to calculate, you can determine each month’s financial obligation beforehand and plan your loan repayments accordingly. This way, you won’t overborrow beyond your repayment capacity.

• Prepayments help reduce EMIs

In case you prepay a part of your loan principal, you will also get the benefit of reduced EMIs from the next repayment instalment. This is because the fixed lending rate is applied on the principal sum, which reduces after a prepayment.

The reducing balance method

In the reducing balance method, each EMI you pay the bank consists of a principal component and an interest component. So, with each EMI, the principal amount that needs to be paid back reduces. This, in turn, reduces the interest component in subsequent EMI payments. Typically, the reducing balance method for bank loans is applied on products like housing loans and other property loans, overdraft facilities and even credit cards.

The formula for computing EMIs as per the reducing balance method is as follows.

Here, P is the principal, I is the annual rate of interest, and T is the repayment tenure in years.

The advantages of the reducing balance method

One of the most beneficial features of a loan that follows the reducing balance method for interest calculation is that over time, the total amount of interest payable reduces. This means the overall burden of interest is a bit less in this method than in the flat rate method, provided you pay all your EMIs on time, as per the repayment schedule.

Sometimes, a flat rate loan with a lower rate of interest may result in a higher total interest payment than a reduced balance loan with a higher interest rate. So, when you are comparing loan offers, it is not just the loan interest rates that you need to look at. You also need to take the method of interest calculation into account.

Conclusion

Now that you are aware of how the flat rate method and the reducing balance method work, you can make a more informed choice about the kind of bank loan you wish to avail. Keep the mechanics of each method in mind, compare the financial obligations you’ll take on in each case, and see which is more beneficial and affordable for you based on your current financial situation.