Invoice Bazaar Blog

Difference between flat interest rate and reducing balance interest rate

By Invoice Bazaar | October 11, 2020

Flat or fixed interest rate and reducing or diminishing balance interest rate are two different methods used by banks and financial institutions for calculating the total amount of interest payable by their customers on the loans availed by them.

In the flat rate method, the total interest payable is calculated on the full original loan amount (the principal) for the entire loan tenure without considering that monthly repayments reduce the principal amount. So the interest amount to be paid every month will remain the same or fixed throughout the loan tenure.

Under the reducing balance method, the interest payable is calculated every month on the outstanding loan amount after deducting the repayments already made until then. Hence, the interest amount in subsequent months keeps on declining. Calculating the interest payable under flat rate method is much easier and more straightforward as compared to the reducing balance method, in which the calculations can become quite tricky.

If the interest rate applicable for loans under both the flat and reducing methods is the same, the borrower should invariably prefer the reducing balance method to the flat rate method as the loan taken under the latter method will turn out to be much more expensive than the loan availed under the reducing balance interest rate method.

If you are planning to take a loan and find that the calculation of interest component is too complicated, then you need not worry as there are any number of online loan calculators that you can access and make use of on your computer systems. It will enable you to know the total interest amount you will have to pay over the entire loan tenure under the two methods mentioned above.

Last but not least, you should always remember that generally, the interest component under the flat interest rate works out 1.7 to .9 times more when it is converted to the equivalent of the reducing balance interest rate. Hence, while taking a loan, you should choose the applicable interest rate based on this fact.