Flat Interest Rate Vs Reducing Balance Interest Rate

Reducing-balance-EMI_loanbaba

Choosing the most affordable loan package is a prerogative when you think of applying for a loan. The affordability of a loan is based on a number of factors such as the rate of interest, EMI, tenure, transferability, pre-payment options, etc. Of all these, rate of interest and the EMI are the two factors most commonly considered to assess the suitability of a loan offer.

Rate of interest is the amount that is charged by the lender on the total amount of loan borrowed. EMI, or the Equated Monthly Instalment, is the amount you pay each month towards the loan. It is the sum of the principle amount and the interest amount.

When you apply for a loan, you will usually be presented with the options of flat rate of interest and reducing the balance EMI. A flat rate of interest is the interest on the principle amount that remains constant through-out the loan tenure. Reducing balance EMI indicates an interest rate that applies to the outstanding loan amount, year after year.

For instance, if you take a loan of Rs. 1,00,000 with a flat rate of interest of 10%, for a tenure of five years.

Tenure (in years) Outstanding Balance Principle (each year) Interest (Each Year) Total Payment (each year)
1,00,000 (loan amount)
1 80,000 20,000 10,000 30,000
2 60,000 20,000 10,000 30,000
3 40,000 20,000 10,000 30,000
4 20,000 20,000 10,000 30,000
5 0 20,000 10,000 30,000
Total 1,00,000 50,000 1,50,000

 

Compare this with a loan of Rs. 1,00,000 with reducing balance EMI at 10%interest rate, for a tenure of five years.

Tenure (in years) Outstanding Balance Principle (each year) Interest (Each Year) Total Payment (each year)
1,00,000 (loan amount)
1 83,620 16,380 10,000 26,380
2 65,603 18,018 8,362 26,380
3 45,783 19,819 6,560 26,380
4 23,982 21,801 4,578 26,380
5 0 23,982 2,398 26,380
Total 100,000 31,899 131,899

 

If you compare both the tables, you will notice that there is significant difference between the total amount you pay towards repayment of the loan. The reducing balance EMI seems to be a better option as the borrower need not pay extra interest. The borrower is charged interest only for the outstanding principle amount. Thus, consider your loan repayment plan carefully, assessing all factors, before deciding on one.

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