Flat vs Reducing interest rates

Interest is a portion of the EMI over and above the principal amount which is repaid to the lender as consideration for using their money. Interest rate is usually depicted as a percentage of the loan which is calculated annually also known as Annual Percentage Rate (APR). Each EMI repayment has a portion which goes towards the principal amount and the rest is allocated to interest.

There are two ways in which rates are calculated by lenders to help determine interest on a loan. The first is calculation of interest on the initial principal and the other calculates interest on the outstanding balance.

Reducing or Diminishing Rate of Interest

In this case the interest rate is calculated on principal amount outstanding at the end of a specific period. As detailed before, every EMI contains a portion that is adjusted against the principal and the balance goes towards interest. Under reducing balance the interest for the next EMI is always calculated on the outstanding principal in the loan after deducting the amount already paid.

For example, assume a loan amount of Rs 5,00,000 with an interest rate of 15% which needs to be repaid in 5 years. The EMI in this case would be Rs 11,895 per month. In the 1st year, a total EMI of Rs 1,42,740 is paid of which Rs 72,596 is towards principal and the balance Rs 70,144 towards interest. Interest the next year is calculated at 15% only on the balance principal amount i.e. Rs 4,37,404. Using this logic, a borrower benefits if a part-payment offer is available as reduced principal will lead to lower EMIs. Most banks and NBFCs offer an interest rate which is based on the reducing balance method

Flat Rate of Interest

In this case the rate is calculated on the initial principal amount without accounting for the principal repaid. This method of interest calculation results in a higher EMI and generally used for short-term loan where the principal is low. Private lenders and P2P companies mostly rely on this method for interest calculation.

Assuming a loan of Rs. 1,00,000 loan at a 10% rate, the interest accrued every year would be 10,000. If the tenure of the loan is 3 years, the combined amount of principal and interest would amount to Rs 1,00,000 + Rs, 30,000 which is Rs 1,30,000. This will be divided by 36 months to arrive at an EMI of Rs. 3,612 per month. Under the reducing balance approach this EMI would amount to Rs 3,227 per month.

You can check the Cashkumar Flat Rate vs Reducing Rate calculator for more information.