Interest is an additional amount paid to the lender on top of the principal loan amount. Various banks similarly calculate loan interest rates. The interest rate is typically expressed as a yearly percentage of the loan, also known as the Annual Percentage Rate (APR). Each Equated Monthly Installment (EMI) payment consists of a portion that goes towards the principal and a part towards the personal loan interest. In most loan interest rate agreements, the interest component is higher in the initial EMIs and decreases as the EMIs progress.
On the other hand, the EMI calculated against the principal amount is smaller at the beginning of the EMI repayment and increases as the term progresses. There are multiple methods for calculating interest rates, and depending on the technique, you may get the lowest interest rate for a personal loan.
The first method depends on whether the interest is calculated on the original principal or the remaining outstanding principal. The difference between reduced and flat balance interest rates is explained below.
Flat Interest Rate
A Flat Interest Rate is a lending rate that remains constant throughout the loan. In this case, the interest is computed on the entire loan amount at the start of the loan period. The financial institution determines the repayment schedule and sets the Equated Monthly Installments (EMIs) to be paid by the borrower. This method ensures that the total repayment obligation for a borrower is fixed, aiding in financial planning in advance. Generally, flat interest rates tend to be higher than reducing rates.
Reducing Interest Rate
In this case, the personal loan interest rate is calculated based on the remaining principal amount at the end of a specific period. As mentioned, each EMI payment is divided into two parts: one part goes towards the principal, and the other goes towards the interest. When calculating interest, subsequent computations are based on the remaining principal balance, not the initial principal amount.
Differences Between Flat Vs Reducing Interest Rate
Here are the key differences between them:
- In the case of a reducing rate, the interest rate is accumulated at a diminishing rate and is based on the remaining loan amount. On the other hand, a flat interest rate involves calculating the interest on the total sanctioned principal amount.
- Under a flat rate, interest is typically calculated at a fixed percentage, usually higher than the reducing interest rate.
- Calculations using a flat rate result in a higher equivalent interest rate, while reducing rates show the effective interest rate from the beginning.
- Calculating a flat interest rate is generally simpler than calculating reducing interest rates.