Planning to get a loan to buy a property? You will get your loan from either a bank or a non-banking financial company. No matter from which agency or institution you get your loan sanctioned, you will be paying interest. The loan interest is calculated in two ways: flat interest rate and reducing interest rate.
How much total money you pay back (principal plus interest) depends on whether you opt for a flat interest rate or a reduced interest rate. What’s the difference? Let’s find out.
What is a flat interest rate?
Flat interest is calculated on the full loan amount and distributed across the entire tenure. This way, you pay a fixed amount to the financial institution from which you have taken the loan. Your EMI is not subject to fluctuations in interest rates.
With a flat interest rate, you know how much you will be paying, for example, for the next 60 months, and consequently, you can plan your finances accordingly.
What is a reducing interest rate?
Contrary to a flat interest rate, in the case of reducing interest rate, your EMI is not calculated on the entire loan amount for the entire tenure, but on the reducing principal amount. A reducing interest rate is calculated on the outstanding balance or the remaining loan.
As you know that the EMI that you pay consists of interest and principal amount. It means, whenever you pay an EMI, you also pay back a part of the principal amount. So the money that you owe to your bank is constantly reducing. In reducing interest rate, your monthly payment is calculated on this reduced amount rather than the entire principal amount.
How much you pay varies every month. Your interest rate is subject to the ongoing interest rate rather than the interest rate that was in the beginning of your loan tenure.
How is flat interest rate calculated?
The flat interest rate is calculated on the total principal amount and then distributed across the tenure evenly. The EMI does not take into consideration the repayment of the principal amount as the tenure progresses. The interest rate and the payable amount remain the same every month.
The flat interest rate is calculated using the following formula:
Interest payable per instalment = (original loan amount x interest rate per annum x number of years) ÷ number of instalments
That is, the original loan amount multiplied by the interest rate per annum multiplied by the number of years for which you have taken the loan, and then the entire calculation divided by the number of instalments you have agreed to pay to pay back the entire loan.
Suppose you have taken Rs. 100,000 as a loan with 5% interest that you intend to pay back in 10 years.
How many EMIs are you going to pay in 10 years? 12 months x 10 = 120 months = 120 EMIs.
This is how the flat interest rate for every month will be calculated:
(100,000 x 5% x 10) / 120 = Rs. 417 (approximately).
This is not the EMI. To calculate the EMI, to this flat interest you also need to add the principal amount.
The principal amount needs to be distributed over 120 months.
100,000 / 120 = Rs. 834 (approximately).
So, if you take a loan of Rs. 100,000 with a flat interest rate of 5% and with a tenure of 10 years, your EMI is going to be
417 + 834 = Rs. 1,251 (approximately).
How is reducing the interest rate calculated?
As previously explained, reducing the interest rate means that the interest is calculated on the outstanding principal amount and not the whole amount. Every proceeding EMI is calculated anew based on the loan amount that is pending to be repaid. This type of interest rate is also called “diminishing rate of interest”.
Here is the formula for calculating reducing interest rate:
Interest payable per instalment = interest rate per instalment * remaining loan amount
Suppose you take a loan of Rs. 100,000 with a reducing interest rate of 5% and for a tenure of 10 years.
If you distribute 100,000 over 120 months, the principal amount for every month comes out to be 100,000 / 120 = Rs. 833 (approximately).
The interest rate for the first month will be 100,000 x 5% = Rs. 5,000.
Therefore, the EMI for the first month will be 833 + 5000 = Rs. 5,833.
For the second month, 833 is deducted from your outstanding principal amount, which will now remain 100,000 – 833 = Rs. 99,167.
The interest for the second month will be 99,167 x 5% = Rs. 4,958.35.
Hence, the EMI for the second month will be 4,958.35 + 833 = Rs. 5,791.35.
Every proceeding month, the principal amount that has already been paid is deducted before calculating interest on the amount.
Advantages of a reducing interest rate
Over a period of time, as the principal amount reduces, the EMI you pay is lower than the previous months. This is because your EMI is calculated not on the complete principal amount that you originally took, but the remaining amount after the number of EMIs you have already paid. In many instances, you can even reduce your tenure by adjusting your EMI (paying a little extra).
What is the advantage of a flat interest rate?
Simplicity. You always know how much you’re going to pay every month. The entire amount is equally distributed, so there are no surprises. Even someone with no financial knowledge can calculate the EMI without worrying about how much amount they’re going to have to pay next month. Also, in case the RBI increases interest rates on loans, you won’t be affected.
Conclusion
Every bank and non-banking financial company these days has an online calculator for calculating EMIs for flat and reducing interest rates. The calculator can give you an idea of how much EMI you will be paying for both options.
Both flat and reducing interest rates have their pros and cons. There is a reason why both options exist. Make a choice that best suits your financial plans.