What is The Difference Between Reducing Balance And Flat Rate Interest - MoneyTap Blog
MoneyTap Blog
flat rate interest
Home » What is The Difference Between Reducing Balance And Flat Rate Interest

What is The Difference Between Reducing Balance And Flat Rate Interest

Difference between Reducing Balance & Flat Rate Interest

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.

Shiv Nanda

Shiv Nanda

Shiv Nanda is a financial analyst at MoneyTap who loves to write on various financial topics online. He also advises people on financial planning, investment choices and budgeting skills, and helps them make their financial lives better.

7 comments

This site uses Akismet to reduce spam. Learn how your comment data is processed.

    • Hello Lokesh,
      MoneyTap currently provides a maximum credit limit of up to Rs. 5 lakhs. However, if you make your repayments in time, your credit balance keeps refilling by the same amount. This way, you can continue enjoying this credit limit for as long as you like. You only pay interest on the borrowed amount and not on the entire approved limit.

      To get started, you can download MoneyTap here: http://m.onelink.me/f8483b7b

      Please write to us at hello@moneytap.com for any help you need.

      Regards,
      MoneyTap Team.

    • Hello Jaydeepsinh,

      Thank you for showing interest in MoneyTap.

      MoneyTap is a Credit Line (combination of personal loan & credit card) app, which is available on Google Play Store. You can download the app and finish the application process on your phone in just 4 minutes.

      Download here: http://m.onelink.me/f8483b7b

      Please be ready with your PAN number, ID proof, and address proof. While applying, you will be requested to take a selfie (to be pasted on the application form) and pictures of your ID proof and address proof. Please ensure to take the pictures as per the guidelines mentioned.

      Once you are done with the e-KYC, you will get a simple verification call from us, and we will fix an appointment at your convenient time to get your signature on the application form. The entire process to get a credit line set up takes about 2-3 working days.

      Here is the best part about MoneyTap – UNLIKE ANY OTHER LOAN PRODUCT IN THE MARKET, the interest will only be charged on the amount used, not on the whole approved amount.

      Example: if you get approved for 2 lacs, and you withdraw 25k then the interest will only be charged on 25k, which can be converted into flexible EMIs. Each time you pay back, your limit will be topped up again by the same amount (minus the interest).

      Please write to hello@moneytap.com if you have any queries, we’ll certainly help you out. You can also message us on Facebook – https://www.facebook.com/moneytapapp/

      We look forward to welcoming you to the MoneyTap family.

      Regards,
      MoneyTap Team

  • Hello I am interested in personnel loan please call me my what’s up no is 9646371626 my requirements loan amount 50.000 thx

  • Hello Mr Murthy,
    Thank you for showing interest in MoneyTap.

    MoneyTap is a Credit Line (combination of personal loan & credit card) app, which is available on Google Play Store. You can download the app and finish the application process on your phone in just 4 minutes.

    Download here: http://m.onelink.me/f8483b7b

    Please be ready with your PAN number, ID proof, and address proof. While applying, you will be requested to take a selfie (to be pasted on the application form) and pictures of your ID proof and address proof. Please ensure to take the pictures as per the guidelines mentioned.

    Once you are done with the e-KYC, you will get a simple verification call from us, and we will fix an appointment at your convenient time to get your signature on the application form. The entire process to get a credit line set up takes about 2-3 working days.

    Here is the best part about MoneyTap – UNLIKE ANY OTHER LOAN PRODUCT IN THE MARKET, the interest will only be charged on the amount used, not on the whole approved amount.

    Example: if you get approved for 2 lacs, and you withdraw 25k then the interest will only be charged on 25k, which can be converted into flexible EMIs. Each time you pay back, your limit will be topped up again by the same amount (minus the interest).

    Please write to hello@moneytap.com if you have any queries, we’ll certainly help you out. You can also message us on Facebook – https://www.facebook.com/moneytapapp/

    We look forward to welcoming you to the MoneyTap family.

    Regards,
    MoneyTap Team