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How Are Flat & Reducing Interest Rates Different?

Submitted by admin on September 4th, 2024

A loan is made up of two components, the principal amount and the interest amount, both of which must be paid to the lender within a stipulated duration. Almost all banks calculate the interest rate similarly. As a result, this interest rate is represented as a percentage of the actual loan amount, is calculated annually, and is called the Annual Percentage Rate or APR.

Every EMI payment is divided into two components. One pays off the principal and the other goes towards paying the interest rate.

There are various techniques for calculating interest rates depending on which borrowers can avail lower rates.

A vast majority of interest rate contracts commence with EMIs with higher interest payments, which decrease as more EMIs are paid. Conversely, principal-based EMIs start off small and increase later on.

The difference steps from whether the interest rate is calculated on the actual principal sum or the outstanding principal.

To gain more information on how you can avail lower interest rates, let’s explore how flat and reducing interest rates are different.

Flat interest rate

A flat interest rate refers to a lending rate that remains unchanged during the entirety of a loan’s tenure. It is calculated based on the total loan amount when the loan tenure begins. The repayment schedule and EMI amount that a borrower must adhere to are determined by the lender/financial organization/bank.

A flat interest rate helps borrowers figure out or finance their repayments ahead of time. Flat interest rates are higher when compared to reducing rates.

Reducing interest rate

When the interest rate of a personal loan is determined on the basis of the outstanding principal amount at a specific time of the loan repayment tenure, it is known as reducing interest rate.

As mentioned above, each EMI is divided into two parts, one that pays off the principal, and the other that pays off the interest. Hence, when calculated on the basis of the outstanding principal amount and not the original, the reducing interest rate applies.

Primary differences between flat and reducing interest rates

Type of calculation: When it comes to reducing rates, interest rates are applied to the balance loan amount on a diminishing rate basis. A flat interest rate is calculated based on the whole loan amount sanctioned.        

Interest rate equivalence: Flat rate calculation causes a high interest rate equivalence, whereas reducing rates show the initial effective interest rate.

Comparison rate: Flat rates are calculated on a fixed basis, which is unlike the reducing interest rate.

Interest rate calculations: Calculation of flat interest rates are far more straightforward when compared to reducing interest rates.

Summing up

At this point, a natural question is which interest rate is more beneficial for the borrower?

On one hand, flat rates offer a predictable EMI that remains unchanged all through the loan tenure and on the other hand reducing interest rates decrease along with the reducing outstanding loan amount payable.

If you need an expert’s guidance, call and consult an Arthavidhi financial expert today.