Flat Rate versus Reducing Rate

[ecis2016.org] Comparing lenders based on interest rates is important. However, the borrowers should also go a step further to find whether this interest rate is a flat rate or a reducing rate.

In India, big purchases like buying a house, a car or higher education are usually made by taking a loan from a bank or non-banking finance company (NBFC). Borrowers compare several lenders on many parameters like tenor, flexibility in repayment, interest rates, loan-to-value (LTV) ratio, top-up facility, documentation, loan fees, etc. However, the foremost parameter that many borrowers consider is the lender’s interest rate. Many borrowers dig deeper to analyse the flat rate vs. reducing rate impact on the repayment amount over the loan’s entire tenor.      

You are reading: Flat Rate versus Reducing Rate

Now, do the flat rate vs. reducing rate calculation to know the difference and then take a call on which is more lucrative for you based on your cash flows. 

In this article, we will try to cover both these types of interest rates on loans comprehensively. This will give you a fair understanding of what a flat rate loan is and what a reducing rate loan is. This flat rate vs. reducing rate analysis will help you make decisions the next time you will be applying for a loan. 

What is a Flat Rate of Interest on a Loan?

A flat interest rate on your loan means that the interest rate will not change during the lifetime of the loan. It is fixed right from the start and continues that way till the tenor of the loan ends. The interest-based on the flat rate interest rate is computed at the start itself, and then the loan repayment schedule is generated based on that. This is a significant difference in flat rate vs. reducing rate analysis. 

The calculation in this type of loan happens in a way that the interest amount is computed on the complete loan amount and not the outstanding principal amount. When the repayment starts, you pay monthly instalments (EMIs) which have both the components of principal and interest. The principal gets reduced with each EMI, but that aspect is not considered in the flat rate interest computation.   

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The mathematical formula to compute the interest amount payable per EMI is as follows:

Interest payable per instalment = (Total loan amount * Tenor of the loan * Interest rate per annum)/Total number of instalments 

It goes without saying that the monthly instalment (EMI) amount in a flat rate-based loan will be higher since interest is computed on the original loan amount. This is another significant point in flat rate vs. reducing rate analysis. Let’s consider a scenario to understand this situation better.

For instance: You take a loan of Rs 1 lakh for 5 years and the rate of interest is 10% per annum on it. Using the above formula, the total interest you will be paying during the entire tenor of the loan is Rs 50,000. Your monthly instalment will be Rs 2,500, and the total annual EMI amount will be Rs 30,000. Eventually, you will have to repay Rs 1.5 lakh (Rs 2,500 * 5 *12) in total, if you decide to borrow Rs 1 lakh. The effective interest rate is 17.27% per annum as compared to the 10% that we have considered initially. Now, compare this with the reducing rate type of loan to analyse the theory of the flat rate vs. reducing rate. 

What is Reducing the Rate of Interest on a Loan?

In this section, we will see how the reducing rate of interest on a loan works and whether it is lower or higher than the flat interest rate to have an objective understanding of flat rate vs. reducing rate theory. Reducing interest rate or diminishing interest rate on loan is where the interest is computed based on the outstanding principal amount in the loan. You now know that the principal amount gets reduced with every payment towards the monthly instalment (EMI). The interest on the next EMI will be accrued on the principal amount left in the loan, which is arrived at after subtracting the principal amount already paid from the total loan amount. 

The mathematical formula used to compute interest amount in reducing interest rate type of loan is as follows:

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Interest payable per instalment = (Interest rate charged by the lender * Outstanding loan amount)

To have a better picture of how things work here and to compare flat rate vs. reducing rate amount, let’s consider the same case we used in flat rate-based loans. The loan amount is again Rs 1 lakh, with a tenor of 5 years and the interest rate is 10% per annum. If the interest rate is reduced then you will have to pay Rs 10,000 as interest in the first year, then Rs 8,000 in the second year and likewise Rs 2,000 in the fifth year. Eventually, you will end up paying Rs 1.3 lakh in total for the borrowed amount of Rs 1 lakh. 

Compare this total repayment amount of Rs 1.3 lakh with the amount you were paying in a flat rate-based loan where it was Rs 1.5 lakh. This is an important difference in this analysis of flat rate vs. reducing rate. Thus, reducing rate-based loans is a lucrative option for any borrower. 

Flat Rate vs. Reducing Rate: Key Differences

Now that you have some basic understanding of both flat rate and reducing rate-based loans. Let’s now shift our focus on the key differences between these two types in our analysis of flat rate vs. reducing rate-based loans. Here it goes: 

• Computation Basis: Flat rate-based loans are the ones where interest is calculated on the total loan amount sanctioned by the lender. On the flip side, in reducing rate based loans, the interest is computed on the outstanding principal balance in the loan. 
• Effective Interest Rate: Reducing rate loans are lucrative as effective interest rates on them are lower than effective interest rates on flat rate-based loans. 
• Computation Complexity: Flat rate loans are a clear winner here in this study of flat rate vs. reducing rate-based loans. This is because interest amount computation in flat rate loans is easy to calculate as it is straightforward. However, reducing rate loans comes with a tricky calculation as you have to subtract the principal amount from the previous instalment from the total loan amount, to arrive at the interest amount. 
• Rate of Interest Comparison: Generally, flat rates are lower in percentage than reducing balance interest rates in India. 

In a nutshell, there are both pros and cons of flat rate vs. reducing rate type of loans. Reducing rate-based loans are good since you are paying a lower amount during repayment, but its calculation is complicated. Flat rate-based loans are good as the monthly amount does not change and the interest amount is fixed, but you will end up paying more during the entire tenor of the loan. Thus, take a call accordingly based on your monthly cash flows and the interest rate comparison in flat rate vs. reducing rate to arrive at the best deal for yourself. 

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