Choosing the Right Interest Rate: Flat Interest Rate vs Reducing Balance Rate

It is essential to carefully review your loan agreement and pay close attention to details such as the loan amount, EMI, additional fees and foreclosure terms. However, the interest is particularly crucial as different types of interest rates may be applied by the lender. In addition to understanding the interest rate, it is important to grasp the type of interest rate being utilized and how it will affect your loan. 

Two of the most common types of interest rates on loans are - flat interest rates and reducing interest rates (also called reducing balance rates). Allow us to elaborate on these interest rates to ensure a comprehensive understanding. 

Why is it Important for Me to Choose the Right Interest Rate?

Choosing the appropriate interest rate structure holds significant importance for various reasons:

• Lower interest rates benefit borrowers by reducing their overall borrowing costs, while a well-designed structure can result in significant savings over the loan terms. Lenders, on the other hand, need to strike a balance between attracting borrowers and earning a return on their capital. 
• The monthly payments of your cash flow are determined by the interest rate structure you choose. It is important to choose a structure that is in line with your income and cash flow to avoid any such issues such as default.
• Differential financial goals may require different interest rate structures. For instance, a fixed rate could be well-suited for a long-term loan where stability is crucial, while an adjustable interest rate might be more suitable for a short-term loan where you anticipate interest rates to decrease. Each structure has its advantage and is best utilized based on the specific financial goal at hand.

Flat Interest Rate Loans

A flare interest rate on a loan implies that the interest is calculated on the entire loan amount and it will remain constant over the loan duration without any changes. The principal amount is used to determine the rate of interest for the loan and this rate will not fluctuate.

Flat interest rates are commonly available in various financial institutions, particularly at non-banking financial institutions including finance companies. 

Which Factors Affect Flat Interest Rates on Loans?

Listed below are the factors that affect flat interest rates on loans:

• Market competition 
• Long loan
• Loan risk level
• Loan amount

Pros and Cons of Flat Rate Loans

In the following table, we have discussed the pros and cons of flat interest rates on loans:

Example Explaining Flat Interest Rate

For a 5-year loan with a principal amount of 10,00,000 rupees and a flat interest rate of 10%, the annual interest payment remains constant at 1,00,000 rupees. Therefore, over five years, the total interest paid would amount to 5,00,000 rupees. 

• Total amount paid for the loan duration = 10,00,000+5,00,000 = 15,00,000
• Annual instalment (Total amount/ Number of years) = Rs. 3,00,000
• Monthly EMI = Rs. 25,000

Reducing Rate Loans

Partial payments made during the term of a loan can further reduce the interest rate, known as reducing interest rate or reducing rate loans. In this case, the interest is calculated based on the remaining loan amount each month. This is also referred to as an annual rest when the principal amount decreases on an annual basis. 

Pros and Cons of Reducing Interest Rates on Loans

Example Explaining Reducing Interest Rate

Assume a 10,00,000 rupees loan at a 10% interest rate. If you repay the loan in 3 years, the total amount to be repaid would be 13,00,000 rupees. This can be divided into 36 months resulting in 36,120 rupees EMI per year. The reducing balance approach would be 32,270 rupees. This is a good personal loan interest rate offered by private lenders for quick loans.

How Should I Choose Between a Flat Interest Rate and Reducing Interest Rate?

When deciding between flat interest rates and reducing interest rates, it is crucial to consider your financial goals, personal preferences and loan purposes. Flat rates offer consistent installments for predictable payments while reducing rates can lead to savings over time. Carefully evaluating both options, taking into account the loan duration and monthly budgeting needs, will help you make an informed decision. 

Can I Switch Between Interest Rates During a Loan Tenure?

In most cases, you cannot switch between interest rates during the loan term. This means that the interest rate and type you select at the start of the loan will remain fixed.

However, there are a few exceptions:

• Convertible loans, offered by certain lenders, permit borrowers to transition from an adjustable-rate mortgage (ARM) to a fixed-rate mortgage (FRM) at a predetermined point within the loan duration. However, it is important to note that this option typically incurs additional fees.
• It is important to understand that a lender agreeing to a loan modification with a rate change is quite uncommon and typically only occurs in certain situations, such as financial hardship. Therefore, if you are facing difficulties with your loan and believe a rate change could help, it is crucial to communicate openly with your lender to explore all potential options.

It is advisable to consult with your lender before obtaining a loan to fully comprehend the terms and any possibility of future adjustments.

Related Posts;

• Cumulative and Non-Cumulative FDs
• Fixed-Rate vs. Adjustable-Rate Mortgages
• Difference Between Secured and Unsecured Loans
• Difference Between Banks and NBFCs
• Types of Home Loans Available in India

Author: Abhik Das