Banks and non-banking financial companies (NBFCs) offer various types of loans to fulfill the monetary needs of the applicants. This form of financial aid could include a personal loan, business loan, home loan, or vehicle loan.
Typically, lenders offer borrowers two kinds of interest rate options – reducing balance rate or a flat rate. A proper understanding of the difference between flat and reducing interest rates can prevent unexpected losses.
A flat interest rate is calculated on the full loan amount throughout its tenure. It does not take into account that the principal amount is gradually reduced by the monthly EMIs.
The nominal flat rate that is quoted in the beginning is noticeably lower than the Effective Interest Rate. The fixed rate of interest is calculated using the following formula –
Interest payable/instalment = (interest rate p.a.*no. of years*original loan amount)/number of instalments
Imagine a scenario where you have taken a personal loan of Rs. 1, 00,000 for 5 years or 60 months at a flat personal loan interest rate of 10%. You will pay
Rs 100,000 (principal) * 10% (flat rate of interest) * 5 (no. of years) / 60 (no. of interest) = INR 833.33 per month. Adding the principal component, your EMI would be INR 2,500 per month. Thus, you would pay INR 10,000 per year or INR 50,000 as interest for the overall tenure of 5 years.
During the entire repayment tenure, the borrower will end up paying Rs.1, 50, 000 (5*12*2,500).
Easy to Calculate and Track
It is easy to calculate using the flat rate method. Loan commitments that are made using the flat interest rate are transparent. They can be easily tracked by both parties, the borrower and the lender.
Meets the Financial Needs of Farmers
Many borrowers, especially farmers in developing countries, prefer loans with balloon payment options. This is because flat rate calculations are easier to understand.
In-kind Loan Transactions
The flat rate of interest method has been around since before currency was invented. It is the most popular way to repay a loan amount using regular instalments.
An interest rate that is calculated on the outstanding loan amount every month is known as the reducing or diminishing interest rate. In this method, the EMI comprises the principal repayment plus the payable interest on the loan amount that is outstanding.
The outstanding loan amount is reduced after every EMI payment. The interest for the following month is calculated only on the outstanding loan amount.
The reducing balance rate is calculated using the following formula –
Interest payable/installment = Remaining loan amount*Interest rate per installment
Consider the example where a borrower avails a loan of Rs.1,00,000 for 5 years at 10% p.a. reducing balance rate. With every repayment, your EMI amount will reduce. In the first year, you will pay an interest amount of Rs. 9,270. In the second year, the principal amount will be Rs. 83,773 and you will have to pay an interest amount of Rs. 7570.
In the last year, you will have to pay an interest of only Rs. 1,329. With the reducing balance method, the borrower will have to pay a total amount of Rs. 1.27 lakhs as opposed to Rs. 1.5 lacs using the fixed-rate method. At Fullerton India, we provide a reducing balance rate of interest, thereby enabling you to repay your loan at the best possible price.
The reducing balance interest method is used to calculate interest payable for personal loans, credit cards, overdraft facilities, property loans, mortgages, and housing. Borrowers pay interest only on the outstanding loan amount.
The big advantage that borrowers enjoy when they avail themselves a loan with reducing balance rates is that, over time, they have to pay less interest than flat interest rate loans.
As is evident, simplicity of calculation and low-interest rates do not necessarily make flat rates beneficial. They can be quite misleading when it comes to repaying large loans.
If you still have doubts, you can always visit the Fullerton India website to know more. Our products and services are uniquely designed to help you meet your financial needs at the most reasonable rates.