Reducing Interest Rate or Flat Interest Rate, which is better?

Reducing Interest Rate

A reducing interest rate is that rate that is calculated every month on the amount that is outstanding for a certain period instead of the whole loan amount.

In this type of interest rate, the EMI amount would include the interest computed on the loan amount that remains outstanding.

The interest component in this case is not calculated on the principal amount but only on the outstanding loan amount.

While computing the reducing interest rate, the formula used to compute the amount of interest on each instalment is:

Interest on each instalment = Outstanding loan amount x interest rate applicable for each instalment.

Flat Interest rate

A flat interest rate is the rate of interest that remains the same throughout the loan tenure as the interest is computed on the principal amount but not on the outstanding amount.

The interest is to be calculated on the whole principle which makes the interest component the same in all the EMIs.

Under the Flat Interest Rate, the formula used to compute the amount of interest on each instalment is:

Interest on each instalment = (Loan principal x total loan tenure x interest rate per annum) / total number of instalments.

Flat Interest Rate Vs Reducing Interest Rate

Every loan seeker has the main question of whether a reducing interest rate or a flat interest rate, which is better?  Before that question, it is important to know the clear meaning of both kinds of interest rates.

The differences between flat interest rate and reducing interest rates can be made on the following basis:

  1. Based on calculation

Under the flat interest rate, the amount of interest is computed on the total principal amount that has been sanctioned as a loan.

Under the reducing interest rate method, the amount of interest accrued is computed on the remaining loan amount.

While taking this point as a comparison, it is clear that the reducing interest rate is much beneficial than the flat interest rate method.

If the interest is calculated only on the remaining amount, the amount of interest reduces as the loan is being repaid.

The burden of interest keeps reducing along with the loan amount, which gives an overall benefit on the EMI amount.

 

  1. Effective interest rate equivalence

Under the flat interest rate method, the calculations result in a higher effective rate of interest equivalence.

Whereas under the reducing interest rate method, the result reflects the effective interest rate initially.

The effective interest rate means the rate of interest on a loan or any financial product restated from the nominal interest rate and it is then expressed as the equivalent rate of interest if the compound interest is payable annually in arrears.

When you wish to compare two interest plans, the interest plan with the higher effective annual rate will be a better choice.

As we discussed, a flat interest rate has a higher effective rate of interest.  Hence, it is a better choice.

 

  1. Comparison of interest rates

The interest rates under the flat interest rate method are rather less than the interest rates under the reducing interest rate method.

If you want to take this as a basis, it is better to choose the flat interest rate method on your loan amount.

But, this is not the only basis, it is important to consider the overall benefit of the interest rates.

When you verify the overall benefit of the interest rates under these two methods, you feel the reducing interest rate method is beneficial than the flat interest rate.

 

  1. Simplicity of calculation

Calculation of interest under the flat interest rate method is much simpler than the reducing interest rate method.

The flat interest rate is calculated directly on the principal amount which makes it easier to compute as the interest amount remains the same throughout the whole tenure.

The system under the flat interest rate is more straightforward in terms of calculation when compared to the reducing interest rate.

Considering all these points of difference, you can choose to take the flat interest rate method or the reducing interest rate method based on your choice.

To be practical, the reducing interest rate method is much better than the flat interest rate method.

Conclusion

Before choosing the method of interest computation for your loan amount, consider your requirements.

Choosing the method of interest computation affects your overall interest rate and thus it is important to see all the requirements before choosing your interest plan.