Choose the better option between flat interest rate or reducing balance rate - Loan Trivia

Thursday 19 November 2020

Interest rate is one of the most crucial aspects for unsecured credits like personal loans as it has a significant impact on the monthly instalment amount and the borrower’s repayment capacity. Before applying for a personal loan, one should have a comprehensive idea regarding the difference between flat vs reducing interest rate and their effects on the principal amount.

These two types of interest calculation method utilised by lending institutions have been discussed below -

Reducing the Balance Interest Rate

In reducing balance interest calculation method, the interest is accrued on the principal outstanding after every EMI payment. Since the outstanding amount reduces after payment of each EMI, the interest payable also reduces.

The formula used in reducing balance interest calculation is as follows –

Interest amount payable in every installment = interest rate applicable on each installment X outstanding loan amount

Following is an example to understand the interest accrual better –

An individual on 5th October 2020 opted for a loan of Rs.5,00,000 for a tenure of 36 months and at a reducing balance interest rate of 12%. In the first month, the borrower will pay an interest of Rs 5000 and Rs 11,607.15 as the principal amount.

Assuming that said borrower has paid his/her EMI on time, and no late fees or penalties have been charged, the total outstanding amount will come to Rs.4,88,392.85. The interest for next month will be calculated on this reduced loan amount. Therefore, in his/her next installment, the interest payable will be Rs 4883.93. This interest amount will continue to decrease as the progresses.

One of the main differences between flat and reducing interest rate is that the latter is usually utilised to calculate interest for credit cards and such products.

Further, with the reducing rate of calculation, individuals can lower their interest payments in due course of the loan tenure.

Flat Interest Rate

In this method, interest is calculated on the overall loan amount that was offered by a lending institution for the entire term. As a result, interest payable does not decrease during the loan tenure, unlike reducing balance interest method. Another point of difference between flat and reducing interest rate is that the former involves simple calculations compared to the latter.

The formula for calculating flat interest rate is as follows –

Interest payable in each EMI = (Original loan amount X No. of years X Interest rate per annum) / Total number of instalments

This can be understood better with an example,

An individual has opted for a personal loan of Rs.5,00,000 on 5th October 2020 at a rate of 12% for 36 months. If the formula for flat interest calculation method is applied, then he or she will have to pay an interest of Rs.5000 throughout repayment period. This type of interest calculation method is generally followed in case of unsecured credits like a personal loan.

Borrowers can use a personal loan EMI calculator offered by financial institutions like Bajaj Finserv to gain an estimation of the monthly instalment amount, which will aid them to draw up a suitable repayment plan, regardless. To compute his/her monthly installment amount, one should enter the following values –

• Required loan amount

• Repayment tenure

• The interest rate charged by a lending institution

Applicants can adjust the loan amount and tenure value on the calculator to figure out a monthly installment that will suit their finances.

The NBFC also provides pre-approved offers on unsecured financial products like personal loans, business loans, credit card etc. for a hassle-free and quick application procedure. Borrowers can quickly check their pre-approved offer by entering their name and contact information.

Besides the interest calculation method followed by a lending institution, one should remember that the type of interest rate he/she opts for also affects EMI amount. Hence, before they apply for a personal loan, individuals should also have a comprehensive idea regarding the pros and cons of different types of interest rates. Here, conducting a comparison of fixed vs floating interest rates and which option offers the most benefits is of utmost importance.