Every time you pay your EMI it consists of both Interest portion and principal portion. Most people are confused about flat rate and reducing balance interest rate. Flat rates are usually lower than reducing balance rates and the normal human tendency is to opt for a rate that is lower because this seems to suggest that the burden on a borrower will be less. But what’s the catch? It’s the details that one must have to be careful about. Let us first get our basic right.
Thus it is very important to understand how banks and other financial institutions calculate the interest rate on a loan before going to apply for the same. Well to describe it simply, when you take a loan for a particular tenure, you need to repay not only the principal amount within that tenure but also the interest on the loan. How the bank/ financier calculate the interest is very important. ‘A% p.a.’ charged on Flat basis is certainly not same as ‘A% p.a.’ charged on Reducing / Diminishing Balance.
Flat interest rate is an interest rate calculated on the full original loan amount for the whole term without taking into consideration that periodic payments reduce the amount loaned. In other words, Flat Rate of Interest basically means that interest is charged on the full amount of the loan throughout its loan tenure. Thus the flat rate does not take account of the fact that periodic repayments (EMI), which include both interest and principal, gradually reduce the outstanding loan amount. Consequently the Effective Interest Rate is considerably higher than the nominal Flat Rate initially quoted.
For instance: If you take a loan of Rs 500,000 with a flat rate of interest of 12% p.a. for 5 years, then you would pay:-
Rs 1,00,000 (principal repayment @ 500,000 / 5)
+ Rs 60,000 (interest @12% of 500,000)
In Reducing / Diminishing Balance Rate method, interest is calculated every month on the outstanding loan balance. EMI payment every month contains interest payable for the outstanding loan amount for the month plus principal repayment. On every EMI payment, outstanding loan amount reduces by the amount of principal repayment. Thus interest for next month is calculated only on the outstanding loan amount as reduced by the principal repayment this month.
For example, if instead of 12% p.a. flat rate (in the above example), interest is charged at 12% p.a. reducing balance rate, EMI amount would reduce with every repayment. With Reducing Interest Rate, The first year you would pay Rs 55,822 as interest, the next year you would pay Rs 45,975 on a reduced principal and so on, till the last year, you pay only Rs 8,286 as interest.
One must note that though a flat rate is lower, it always comes at a higher cost than an annual reducing balance rate. In the latter case, the effective total interest paid out also depends on the time periods – daily, monthly, quarterly, half-yearly and yearly – when the rate is calculated.