Flat Rate vs Reducing Rate
When taking a loan, it's important to understand how interest is calculated. Two common methods are flat interest rate and reducing balance rate:
- Flat Rate: Interest is calculated on the full loan amount throughout the loan tenure.
- Reducing Rate: Interest is calculated only on the outstanding balance, which reduces over time as you repay the principal.
Formula Used
Flat Interest = (Principal x Rate x Tenure in Years) / 100 Reducing EMI = [P x R x (1+R)^N] / [(1+R)^N - 1] Where: P = Principal, R = monthly interest rate, N = total number of months
Example
Let's assume you take a Rs. 1,00,000 loan for 3 years at 10% interest rate.
- Flat Rate:
Interest = Rs. 1,00,000 x 10% x 3 = Rs. 30,000
Total = Rs. 1,30,000 -> Monthly EMI = Rs. 3,611 - Reducing Rate:
Using the EMI formula, monthly EMI comes out to approx Rs. 3,226
Total repayment = Rs. 1,16,136 -> Interest = Rs. 16,136
Frequently Asked Questions (FAQs)
Which loan method is more cost-effective?
Reducing interest rate is generally more cost-effective due to lower interest on reducing principal.
Why do banks offer flat interest?
Flat rates are easier to understand and often used in personal or auto loans. But they usually result in higher total interest.
How can I know if my loan uses flat or reducing rate?
Check your loan agreement or ask the lender. Flat rate loans show constant EMI despite reducing balance.
Does reducing rate always mean lower EMI?
Not necessarily. EMI might be higher but total interest paid over time is lower in reducing rate loans.