Flat Interest Rate vs Reducing Rate of Interest

Difference Between Flat Interest Rate vs Reducing Rate of Interest

03 Sept 2020

When a bank or any other financial institution lends you money it charges you an amount for the period of your loan called the interest amount. The interest amount is calculated as a percentage of the total amount borrowed and the percentage is referred to as the interest rate of the loan. Broadly, there are the types of interest rates — fixed interest rate, floating interest rate and reducing interest rate.

Fixed/Flat Interest Rate

In case of flat/fixed interest loans, the interest amount is calculated on the full amount of the loan, also known as the principal amount. This interest amount remains the same for the entire course of the lending period (that is, till you have fully repaid the borrowed money).

This type of interest rate is usually applied for short-term and traditional personal loans. As the interest amount is stagnant for the entire tenure, this type of loan might turn out to be more expensive than a floating rate of interest loan.

Let’s understand a flat interest loan with an example:

Anuj takes a personal loan of Rs. 2,00,000/- at a flat interest rate of 20% per annum for 2 years.

Here is the breakdown his interest payable and equated monthly instalments:

Total Interest Rate: Rs. 2,00,000 (principal) X 20% (Rate of Interest) X 2 years (tenure) = Rs. 80,000

Monthly EMI = Rs. 2,00,000 (principal) + Rs. 80,000 (interest) / 2 years (tenure) = Rs. 2,80,000 / 24 Months = Rs. 11,666.67

As such Anuj ends up paying Rs. 2,80,000 as the total repayment toward the loan at a monthly EMI of Rs. 11,667 for two years .

Diminishing or Reducing Rate of Interest

The diminishing or reducing rate of interest is calculated based on the outstanding loan amount after periodic repayments. Being the preferred option compared to the flat interest rate, the reducing rate is used to calculate the interest amount for overdraft facilities and credit cards. This method is beneficial to the customers since they have to pay a smaller interest amount as the loan tenure progresses since the interest is calculated based on the outstanding principal loan amount. In this case, the interest amount decreases after each EMI is paid as the outstanding balance becomes lesser than the previous month.

The formula for the reducing rate of interest is:

Amount of interest for each installment = Applicable rate of interest * Remaining loan amount

Drawing from the previous illustration, Anuj would have to pay an EMI of Rs 10,179 in this case as opposed to Rs. 11,667 if he went for a fixed interest rate personal loan.

Floating rate of interest

There is a third type of interest rate called floating interest. The floating interest rate changes multiple times during the tenure of the loan. The change depends on several factors, including the Reserve Bank of India’s policies, revised lending rates, and other reference data points. This is where the MCLR comes in.

The marginal cost of funds-based lending rate (MCLR) is the minimum rate of interest at which a bank can lend. MCLR is a tenor-linked internal benchmark, meaning the interest rate is determined internally by the bank depending on the duration left for the repayment of a loan. MCLR is calculated based on four components: the marginal cost of funds i.e. the cost of lending an extra rupee, negative carry on account of cash reserve ratio, operating costs and tenor premium. The RBI introduced this methodology for interest rates in 2016. It replaced the erstwhile base rate structure, which had been applicable since 2010.

Personal Loan Interest Rates

Personal loan interest rates are often higher since these are unsecured loans i.e. you don’t put up a collateral as security while availing these loans. However, they are usually a more accessible source of funds for salaried and self-employed individuals than other types of loans.

One important point to take into consideration while availing such a loan is the APR, or annual percentage rate. It includes the interest rate and any other fees to be paid for the loan. Such fees may include processing charges and service charges. Rather than comparing personal loan interest rates or EMIs, it might be better to compare APRs while deciding where to borrow from.

Whether you are planning a trip to your dream destination, renovating your home with modern furnishing, drawing up your dream wedding or dealing with a medical emergency, a personal loan could be helpful in times of need. If you are looking for one, you might want to consider a Bajaj Finserv Personal Loan on Finserv MARKETS. You can avail personalised pre-approved offers, instant approvals, quick disbursal and flexible tenues of 12 to 60 months with a Bajaj Finserv Personal Loan on Finserv MARKETS.


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