Loans and their clauses can often get confusing, and sometimes getting a loan might turn out to be a tedious and long-drawn process. The terms of interest calculation can catch you off guard and you may find it different from what you learnt in school. The fact is, there is a difference in the way financial institutions calculate interest. Which brings us to the two popular ways interest is calculated, namely reducing balance interest and flat rate interest.
What is Flat Rate Interest?
Flat rate interest is simpler as compared to reducing balance interest. It is the rate of interest which is calculated for the principal loaned amount for the entire term of the loan. It does not take into account the reduction in loan amount due to periodic payments, what this means is that the interest is calculated on the full amount, for the total tenure of the loan. The formula to calculate the interest in this case is:
Interest per Instalment = (Original Loan Amount * No. of Years * Interest Rate per annum) / Total Number of Instalments
To illustrate this method of charging interest, here is an example.
Say a person takes a loan of Rs. 500,000, with a flat rate of interest 10% per annum for a period of 5 years. This person will have to pay: Rs. 100,000 (principal amount repayment yearly) + Rs. 50,000 (interest at the rate of 10% per annum) = Rs. 150,000 payable yearly or Rs. 12,500 per month. Effectively, you would be paying Rs. 250,000 as interest.
This method of interest is usually used to charge interest on personal loans and car loans. Flat interest rates when converted to effective interest rates are usually 1.7 to 1.9 times more than what the flat interest rate actually states.
What is Reduced Balance Interest?
In this method, the interest is calculated every month, and accounts for the periodic payments that reduce the principal amount. For calculating the reduced balance interest, the EMI includes the repayment of the principal amount and the monthly interest calculated on the outstanding loan amount, which reduces every month. What this means is that every time the EMI is paid, the loan amount decreases. The formula for calculating the interest based on the reduced balance system is:
Interest per EMI = Reduced Balance Interest Rate * Outstanding Loan Amount
The following is an example to help explain this way of charging interest.
Say a person takes a loan of total principal amount Rs. 100,000 with a reduced balance interest rate of 10% per annum and for a time of 5 years. At the outset, this implies that the outstanding loan amount keeps decreasing. In the first year, the total interest this person would pay would be Rs. 10,000, which would then become Rs. 8,000 in the second year and would keep on decreasing subsequently. After converting this into effective interest, it is seen that the total interest paid would be Rs. 1.3 lakhs, which is lesser than the fixed rate interest for the same principal loan amount. This method of interest is usually used for home loans, mortgages, credit cards, and overdraft facilities.
Differences Between Reducing Balance Interest And Flat Rate Interest
- The first, and quite obvious, difference is the fact that in the flat rate method, the interest is solely calculated on the principal loan amount whereas in the reducing balance method, the interest rate is calculated on the outstanding loan amount which changes after every EMI payment.
- Secondly, the interest paid is lower for the reducing balance method as compared to the flat rate method.
- Thirdly, when compared to reducing balance interest rates, flat interest rates are normally lower.
- Finally, calculating and computing the flat rate form of interest is relatively easier than the reducing balance interest.
Always consider the type of interest you will pay before taking a loan. This is because the effective interest that you will end up paying will differ based on the method of charging interest.