Flat Interest Rate vs. Reducing Balance Interest Rate: Definition and Advantages

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.

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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 Interest Rate Method

A Flat Interest Rate means a lending rate that stays unchanged through the loan tenure. In this case, the interest rate or lending rate is fixed for the duration of your loan, and it will be calculated at the start of your loan tenure. Here, the monthly EMI or Equated Monthly Installment is calculated using the formula given below.

Monthly EMI = ( P + (P *I* T)/100) / T*12

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 interest 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.

Monthly EMI = [P x Ix (1+I) ^T]/ [((1+I) ^T)-1)]

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.

Difference Between Flat and Reducing Interest Rate

The primary distinction between flat and reducing interest rates lies in how the interest is calculated throughout the loan tenure. Let's explore this difference using clear explanations and a side-by-side comparison.

a) Basis of Calculation:

Flat Interest Rate: This rate is calculated based on the principal amount of the loan throughout its tenure. The interest doesn't decrease even as you continue paying down the loan.
Reducing Interest Rate: Calculated on the remaining loan balance, this rate decreases as you pay off the principal. This means you pay interest only on the outstanding loan amount.

b) Effective Interest Rate Equivalence:

Flat Interest Rate: This may appear lower at first glance, but the effective rate of interest paid is generally higher as it is calculated on the entire loan amount.
Reducing Interest Rate: While initially seeming higher, the effective rate is typically lower as interest is calculated on the decreasing balance.

c) Rate Comparison:

Flat Interest Rate: Simpler to compare because it remains consistent throughout the loan term.
Reducing Interest Rate: Comparisons can be trickier due to the declining balance method, affecting how much interest you pay over time.

Criteria	Flat Interest Rate	Reducing Interest Rate
Basis of Calculation	On total principal amount throughout the loan tenure	The remaining loan balance decreases as you pay
Interest Rate Equivalence	Higher effective interest rate	Lower effective interest rate
Simplicity	It is easier to calculate and understand	Requires calculations as balance decreases
Cost-Effectiveness	Less cost-effective over time	More cost-effective in the long run

Flat or Reducing Interest Rate: Which is Better?

Deciding whether a flat or reducing interest rate is better depends largely on your financial situation and how you manage your loan.

Flat Interest Rate:

Pros: Easy to budget as payments are predictable.
Cons: Ultimately, it is more expensive as you pay interest on the original loan amount throughout the tenure.

Reducing Interest Rate:

Pros: Decreases interest costs over time, as interest is calculated on the reducing balance.
Cons: Initial payments can be higher, affecting the borrower's budget.

Frequently Asked Questions

Q1: What is the advantage of a flat rate?

The biggest perk of a flat rate is its predictability—since the payment amount doesn't change, budgeting becomes simpler.

Q2: How is the interest calculated at a flat rate?

Interest is calculated on the full loan amount initially borrowed and remains the same, regardless of how much principal has been repaid.

Q3: Which method is easier to calculate?

The flat rate method is generally easier because it involves straightforward calculation and does not change over time.

Q4: How can I know my EMI before taking the loan?

You can estimate your EMI using online calculators provided by banks. Just input your loan amount, term, and interest rate for an instant calculation.

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.