What Is the Difference
Understanding the difference between flat-rate and variable-rate interest on personal loans is essential. Both methods calculate interest differently and can significantly impact your total repayment amount over the loan tenure.
What Is a Flat Interest Rate ?
A flat rate calculates interest on the original principal amount throughout the entire loan tenure. Even as you repay the loan, the interest charged remains constant and does not reduce with the outstanding principal balance.
How Flat Rate Interest Is Calculated
Under the flat rate method, total interest equals the principal amount multiplied by the interest rate multiplied by the loan tenure in years. This means every EMI carries the same fixed interest component regardless of the repayments made.
What Is a Reducing Rate Interest
A reducing rate calculates interest only on the outstanding principal balance remaining after each EMI payment. As you repay the principal amount each month, the interest charged decreases progressively throughout the loan tenure.
How the Interest Rate Is Calculated
Under the reducing balance method, lenders recalculate interest every month on the remaining principal amount. Each EMI or prepayment reduces the principal, which lowers the total interest paid over time.
Flat Rate vs Reducing Rate: Cost Comparison
A flat rate personal loan always costs more than a reducing rate loan at the same stated interest rate. The effective interest rate on a flat-rate loan is approximately 1.7 to 1.9 times higher than the stated rate.
Impact of Prepayments on Both Methods
Prepayments significantly benefit in reducing the rate of personal loans as they directly lower the outstanding principal, reducing future interest charges. Under the flat rate method, prepayments offer less financial benefit as interest is fixed on the original principal amount.
Which Interest Rate Method Should You Choose
Always opt for a reducing rate personal loan over a flat rate when given the choice. Compare the effective interest rate rather than the stated rate to understand the true cost of borrowing before signing any personal loan agreement.
Disclaimer: The information provided on this website is for general informational purposes only and should not be considered financial or legal advice. Please consult with a qualified financial advisor before making any decisions.
