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Loans offered by lending institutions attract one of the two kinds of interest rates: reducing balance rate and flat rate interest rate. It is important to know what sets both of these two apart so that you can decide which one will work best for you. Read on to know more.

What is the Flat Interest Rate System

A flat interest rate system is calculated on the entire loan amount beforehand. It does not account that the principal sum is reduced over the course of the repayment tenure. Hence, the EMI obligation remains static throughout the tenure if other factors remain constant.

It is calculated with the help of the following formula:

(Principal Amount x Flat Interest Rate (percentage or decimal) x Length of the repayment tenure (In years)) / Repayment tenure (Expressed in Months)

To illustrate with an example, let us just assume that Mr. Singh has secured a personal loan of ₹2,00,000 at a flat interest rate of 10% that he is going to repay over 10 years.

Given the above figures, the interest component of your monthly personal loan EMI outflow will look as follows:

(₹2,00,000 x 10% x 5)/60 = ₹1,666.67

So, your total interest payable over the course of your repayment tenure (5 years) will be:

₹1,666.67 x 60 (months) = ₹1,00,000

Now, let us add the principal amount to the above figure, which is another ₹2,00,000. So, the total amount that will be paid to the borrower will amount to ₹3,00,000. This will be paid off in 60 EMIs, so the borrower’s monthly outflow will be approximately ₹5,000 a month.

Advantages of Flat Interest Rate System

  • Easy to Manage: Since it is relatively simple to calculate and understand, it is easy for all parties involved to keep track.

  • EMI Obligation Remains Static: Your monthly EMI obligation remains the same throughout the tenure, making it easier for you to plan your budget. 

What is the Diminishing Balance Interest Rate System

The interest rate which is calculated on the outstanding principal loan amount is known as the reducing or diminishing balance interest rate system. The EMIs of loans with this kind of interest rate are made up of two parts: outstanding principal amount and the interest calculated on the principal. The interest component of every instalment is calculated simply by multiplying the remaining loan amount to the interest rate per instalment.

Advantages of Taking a Loan With Reducing Balance Interest Rate

As you can imagine, borrowers that take up a loan with a reducing balance interest rate system pay a lesser amount as interest over time. This is because the interest component of every subsequent EMI is calculated on the outstanding loan amount.

Reducing Balance vs Flat Rate Interest System

Some differences between the two forms of interest rates are:

Particulars

Flat Interest Rate System

Reducing Balance Interest Rate System

Basis of interest calculation

Calculated on the total principal amount

Calculated on the total remaining principal amount

Interest liability

Higher as compared to the interest charged under the reducing balance interest rate system

Lower as compared to the interest charged under the flat rate system

Level of complexity in calculation

Simpler to calculate than in the case of the reducing balance system

Relatively complex to calculate as compared to the flat interest rate system

Who prefers them and why?

The likes of farmers prefer the flat rate interest rate system as it is simple to calculate and understand

People living in urban areas prefer the reducing balance interest rate system as the overall interest liability is lower as compared to the interest rate payable under the flat interest rate system

Conclusion

Although relatively complex to calculate, it is clear that a personal loan with a reducing balance interest rate system will be more pocket friendly for you. You can avail one from Finserv MARKETS itself through any of our lending partners. As a Finserv MARKETS user, you will be able to enjoy benefits such as flexible repayment tenures, competitive interest rates and loan top ups. Apply Now!