Lenders calculate loan interest in two ways: flat interest rate and reducing interest rate. Both methods of calculation result in a different interest amount payable by you, the borrower.

🔸 Flat Interest Rate:

As the title suggests, a flat interest rate is one that is computed on the whole amount of the loan during its duration, without taking into account the fact that monthly EMIs slowly reduce the principal amount. As a result, the Effective Interest Rate is significantly greater than the initial nominal Flat Rate.

➡️For example, if you borrow Rs 2,00,000 for 5 years at a fixed rate of 10% p.a., you will pay:

Rs 40,000 (principal repayment @ 1,00,000 / 5) + Rs 10,000 (interest @ 10% of 1,00,000) = Rs.50,000 every year or Rs.4167 per month.

You’d end up paying Rs. 2,50,020 (4167*12* 5) over the course of the entire period.

As a result, the EMI of Rs. 4167 per month changes to an effective interest rate of 17.27 percent per annum in this example.

🔸 Reducing Interest Rate:

As the title suggests, a reducing/diminishing balance rate is an interest rate computed monthly on the outstanding loan amount. The EMI for this option covers interest on the outstanding loan amount for the month as well as the principal payments. The outstanding loan balance decreases with each EMI payment. As a result, the next month’s interest is based only on the outstanding loan balance. This is the actual difference between flat rate and reducing rate.

➡️For instance:

If you take a loan of Rs. 2,00,000 for 5 years at a reducing rate of interest of 10% p.a., your Inter payments cost will decrease with each payment and at the end you have paid ₹54,965 in interest in reducing balance and compared ₹1,00,000 on Flat rate i.e ₹45,035 savings.

Source: nobroker, groww
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