Difference between flat and reducing interest rate

When you take out a loan for a specific length of time, you must repay both the principal and the interest within that time frame. Other than the loan rate, I know it's critical to understand how the bank calculates interest on your house loan. The flat interest rate method and the reducing balance interest rate approach are the two most commonly used methods for calculating interest on loans. Let’s see the flat rate vs reducing rate concept.

Difference between flat and reducing interest rate:

Flat Interest Rate:

As the title suggests, a flat interest rate is one that is computed on the whole amount of the loan during its duration, without taking into account the fact that monthly EMIs slowly reduce the principal amount. As a result, the Effective Interest Rate is significantly greater than the initial nominal Flat Rate. The following is the formula for computing a fixed rate of interest:

Interest per Instalment = (Actual Loan Amount * Total Years * Interest Rate per year) / Total Number of Instalments

For example, if you borrow Rs 2,00,000 for 5 years at a fixed rate of 10% p.a., you will pay:

Rs 40,000 (principal repayment @ 1,00,000 / 5) + Rs 10,000 (interest @ 10% of 1,00,000) = Rs.50,000 every year or Rs.4167 per month.

You'd end up paying Rs. 2,50,020 (4167*12* 5) over the course of the entire period. 

As a result, the EMI of Rs. 4167 per month changes to an effective interest rate of 17.27 percent per annum in this example. 

Reducing Interest Rate:

As the title suggests, a reducing/diminishing balance rate is an interest rate computed monthly on the outstanding loan amount. The EMI for this option covers interest on the outstanding loan amount for the month as well as the principal payments. The outstanding loan balance decreases with each EMI payment. As a result, the next month's interest is based only on the outstanding loan balance. This is the actual difference between flat rate and reducing rate.

Reduced balance interest is calculated using the following formula:

Interest To Pay Per Installment = Interest Rate for Every Installment * Total Loan Amount Left

For instance:

If you take a loan of Rs. 2,00,000 for 5 years at a reducing rate of interest of 10% p.a., your EMI cost will decrease with each payment. You would pay Rs. 20,000 in the interest the first year, Rs. 18,000 on a reduced principal of Rs 80,000 the second year, and so on, until you only paid Rs.12,000 in the interest the last year. You would pay Rs. 2.8 lakh instead of Rs.3 lakh if you used the fixed-rate option.

Now you know the concept of flat rate vs reducing rate.