Loans and their clauses can often get confusing, and sometimes getting a loan might turn out to be a tedious and long-drawn process. The terms of interest calculation can catch you off guard and you may find it different from what you learnt in school. The fact is, there is a difference in the way financial institutions calculate interest. Which brings us to the two popular ways interest is calculated, namely reducing balance interest and flat rate interest.

What is Flat Rate Interest?

Flat rate interest is a method where the lender calculates interest on the original loan amount for the entire loan tenure. The interest amount remains the same throughout the repayment period, regardless of how much of the principal you have already repaid.

This means that even though your outstanding loan balance decreases every month, the interest is still charged on the initial loan amount.

Example

Say a person takes a loan of Rs. 500,000, with a flat rate of interest 10% per annum for a period of 5 years. This person will have to pay: Rs. 100,000 (principal amount repayment yearly) + Rs. 50,000 (interest at the rate of 10% per annum) = Rs. 150,000 payable yearly or Rs. 12,500 per month. Effectively, you would be paying Rs. 250,000 as interest.

As a result, your monthly EMI remains fixed, but you end up paying interest on money you have already repaid.

What is Reduced Balance Interest?

In this method, the interest is calculated every month, and accounts for the periodic payments that reduce the principal amount. For calculating the reduced balance interest, the EMI includes the repayment of the principal amount and the monthly interest calculated on the outstanding loan amount, which reduces every month. What this means is that every time the EMI is paid, the loan amount decreases. The formula for calculating the interest based on the reduced balance system is:

Interest per EMI = Reduced Balance Interest Rate * Outstanding Loan Amount

The following is an example to help explain this way of charging interest.

Say a person takes a loan of total principal amount Rs. 100,000 with a reduced balance interest rate of 10% per annum and for a time of 5 years. At the outset, this implies that the outstanding loan amount keeps decreasing. In the first year, the total interest this person would pay would be Rs. 10,000, which would then become Rs. 8,000 in the second year and would keep on decreasing subsequently. After converting this into effective interest, it is seen that the total interest paid would be Rs. 1.3 lakhs, which is lesser than the fixed rate interest for the same principal loan amount. This method of interest is usually used for home loans, mortgages, credit cards, and overdraft facilities.

Differences Between Reducing Balance Interest And Flat Rate Interest

Conclusion

Understanding the difference between reducing balance interest and flat rate interest can help you make a more informed borrowing decision.

If your goal is to minimize the total interest paid over the loan tenure, a loan with a reducing balance interest method is generally the more cost-effective choice because interest is charged only on the outstanding principal.

A flat rate interest method may seem straightforward, but it usually results in a higher overall borrowing cost since interest is calculated on the original loan amount for the entire repayment period.

Before taking any loan, compare more than just the advertised interest rate. Evaluate how the interest is calculated, the total repayment amount, applicable fees, loan tenure, and repayment flexibility. Taking the time to compare these factors can help you choose a loan that aligns with your financial goals and budget.