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Flat interest rate
Reducing balance interest rate
Every loan offer sounds tempting when the rate seems low. “Just 8% interest,” says the ad, as if money were an obedient friend who returns exactly when called. But behind those friendly numbers lies a quiet trick — the difference between flat and reducing interest rates. One keeps you paying for what you’ve already repaid; the other treats your repayments fairly. Understanding this difference is the key to knowing what you truly pay.
What Is a Flat Rate of Interest?
Under a flat rate system, interest is charged on the entire principal amount throughout the loan tenure, regardless of how much you’ve already repaid.
This means even after paying back most of your loan, the interest is still calculated on the original loan amount.
Formula:
Total Interest = (Loan Amount × Rate × Tenure) / 100
EMI = (Principal + Total Interest) / (Tenure × 12)
Example:
Loan = ₹1,00,000
Interest = 10% per annum (flat)
Tenure = 5 years
Total Interest = ₹1,00,000 × 10% × 5 = ₹50,000
Total Payable = ₹1,00,000 + ₹50,000 = ₹1,50,000
So, while the rate looks like “10%,” the effective annual cost is much higher — closer to 17.9%, once you account for the fact that you’re paying interest on money that’s already repaid.
What Is a Reducing (Diminishing) Rate of Interest?
The reducing rate, also called the diminishing balance or declining balance method, is fairer and more accurate.
Here, the interest is calculated each month on the remaining principal balance, not the full loan amount.
As your EMIs go out, the principal reduces — and so does your interest burden.
Formula:
EMI = [P × r × (1 + r)^n] / [(1 + r)^n – 1]
where:
P = Loan amount
r = Monthly interest rate
n = Total number of EMIs
Example:
Loan = ₹1,00,000
Rate = 10% p.a. (reducing)
Tenure = 5 years
Total Interest ≈ ₹27,000
Total Payable ≈ ₹1,27,000
That’s a difference of ₹23,000 compared to the flat rate example — on the same amount, at the same “10% interest.”
Flat vs Reducing Rate – Quick Comparison
| Basis | Flat Rate | Reducing Rate |
|---|---|---|
| Interest Calculation | On full loan amount throughout tenure | On remaining balance |
| Effective Cost | Much higher | Lower and fair |
| Clarity | Often misleading | Transparent |
| Loan Type | Vehicle, consumer durable, microfinance loans | Home, education, and personal loans |
| Ease of Calculation | Simple | Slightly complex |
| Fairness | Poor – ignores repayments | High – reflects actual outstanding |
Why Does the Flat Rate Still Exist?
Because it looks cheaper.
Many lenders — especially in the unorganized sector (like small finance companies or NBFCs offering vehicle loans) — advertise flat rates to make their loans appear attractive.
Borrowers see “8% flat” and compare it to “10% reducing,” assuming the first is cheaper.
But in truth, 8% flat ≈ 14.5% reducing.
It’s marketing dressed as mathematics.
Banks and regulated lenders, on the other hand, prefer reducing rates because they align with RBI guidelines and reflect real-time borrowing costs.
How to Convert Flat Rate to Reducing Rate (and Vice Versa)
If you ever come across a flat rate and want to know its true cost, here’s a rough conversion:
Effective Reducing Rate ≈ Flat Rate × 1.82
So,
8% flat ≈ 14.6% reducing
10% flat ≈ 18.2% reducing
And if you want to reverse it:
Flat Rate ≈ Reducing Rate / 1.82
Real Impact on EMIs and Repayments
Let’s say two friends — Rohan and Meera — each borrow ₹5,00,000 for 5 years.
- Rohan’s loan is at 10% flat rate.
- Meera’s loan is at 10% reducing rate.
| Particulars | Rohan (Flat Rate) | Meera (Reducing Rate) |
|---|---|---|
| Principal | ₹5,00,000 | ₹5,00,000 |
| Tenure | 5 years | 5 years |
| Nominal Rate | 10% | 10% |
| Total Interest | ₹2,50,000 | ₹1,35,000 (approx.) |
| Total Repayment | ₹7,50,000 | ₹6,35,000 |
| Effective Cost | ~18% | 10% |
Meera saves ₹1,15,000 — simply because of the way her interest was calculated.
Pros and Cons
| Flat Rate | Reducing Rate | |
|---|---|---|
| Pros | Easy to understand, predictable EMIs | Fair, true cost of borrowing |
| Cons | Misleadingly low rate, higher cost | Slightly complex math |
| Best for | Short-term or small consumer loans | Long-term loans like home, education, or business |
How to Know Which Rate You’re Being Offered
Most loan documents mention the rate type in fine print.
Look for keywords like:
- “Flat Rate” or “Fixed Interest on Total Loan Amount” → Flat Rate
- “Interest on Outstanding Balance” or “Reducing Balance Method” → Reducing Rate
If you can’t find it — ask. A good rule: never sign a loan document unless the rate type is clearly mentioned.
How to Choose Wisely
- For short-term loans (say, 6–12 months), the difference may be small — so a flat rate might still be acceptable.
- For long-term loans (3 years or more), always go for reducing rate.
- Use a Flat vs Reducing Rate Calculator to check the true difference before finalizing any loan.
Yogi’s Reflection
A flat rate is like a smiling salesman — friendly, quick, and persuasive.
A reducing rate is like a silent accountant — fair, precise, and patient.
Both get you the money you need, but one makes you poorer in the long run.
A smart borrower doesn’t just compare interest rates — one understands the method behind them. Because in finance, as in life, the truth often hides in the fine print.