written by | October 12, 2022

Difference Between Flat Interest Rate vs Reducing Interest Rate

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Table of Content


Commercial banks, Non-Banking Financial Companies, and other lending institutions offer various forms of loan offerings at a flat or reduced interest rate based on different market factors and speculations on economic indicators. Fixed-rate calculations turn into higher effective interest rate equivalence. On the other hand, reducing rate calculation reflects the effective interest rate initially.

Did You Know? Though banks are independent in their commercial operations and can negotiate favourable earnings on corporate loans and advances. They are regulated by the Secratorial Regulator, RBI, and required to allocate a certain percentage of their advances to developing or emerging sectors at a reduced interest rate. 

Also Read: Types of Loan - What are different Types of Loan in India?

What is a Flat and Reducing Interest Rate?

Before we dive further. First, let us understand what interest is. In financial terms, Interest is an amount of opportunity cost for using the principal amount which would otherwise be put to use elsewhere. In layman's terms, Interest is the part of monthly or yearly loan instalments that the lender charge as a source of his income.

As the name suggests, a flat interest rate is the rate of interest charged by leading institutions from the borrowers at a flat rate, say 10%, throughout the course of money being used or lent to the borrower. A flat rate is beneficial to the borrower since his risk is hedged to the extent of the rate of interest and is unaffected by changes in economic factors or a hike in the market interest rate, such as the repo rate by the RBI. Banks prefer a Flat rate of leading if they speculate on economic instabilities in the near future. This may hedge their risk of any adverse changes in the economic environment. 

For Example - Suppose a bank named Nidhi bank expects that there will be a hike in the repo rate in the near future, and there is a monetary policy in the discussion that may not be favourable to the earning potential of Nidhi Bank. The bank, as a consequence, may hedge its risk by offering a flat rate of interest advances so that the coming monetary policy may not severely affect its earnings.

However, If the market interest rates are expected to hike due to current inflation pressure. The bank may not be willing to disburse loans at a fixed rate rather. The borrowers may want to get the loan sanctioned at a flat rate to hedge the risk of rate hikes in the future. 

A reducing interest rate is the interest rate charged on the left principal amounts as and when the principal amounts are paid off, resulting in a reduced interest cost with each instalment of the loan. Thus, Interest cost diminishes with every instalment as the outstanding loans decrease. It is also known as annual rest. A reduced loan interest rate is beneficial for the borrower as he is required to pay less interest with each instalment. While It is difficult to calculate as interest cost changes each time an instalment is paid, the benefits of reducing interest rates usually outweigh the flat interest rate of interest.

Benefits of Flat Interest Rate Loans

  • It is beneficial for the borrower as he is not required to compensate for any hike in the market interest rate
  • Banks are usually assured of a fixed income from flat-interest loans.
  • Interest costs under flat rates are easy to calculate and can be simplified through a spreadsheet.
  • Banks are required to disburse a certain percentage of their total advances to emerging sectors like farming. Flat rates help banks to provide loans at low cost to farmers.
  • Flat-interest loans are the most popular and widely accepted form of providing loans. 

Benefits of Reducing Rate of Interest 

  • The borrower gets the benefits of the reduced interest costs. This may prompt the borrower to have a low cost for the project. 
  • There is an inherent motivation for the borrower to pay the loan instalments as early as he can. This may reduce his interest costs if early payments reduce the period under the loan.
  • The banks are relatively at low risk compared to flat rate borrowers for defaults since the borrowers regularly pay instalments to avoid a hike in interest costs. 
  • The banks may expect an early recovery of the loan amounts, and the overall risks of defaults get reduced as a consequence.

Also Read: Mudra Loans - Check Out a Complete Guide on How to Apply for Emudraloan

Difference Between Flat Interest Rate and Reducing Rate of Interest

Basis of Difference

Flat Interest Rate

Reducing Interest Rate

Meaning

A flat interest rate is the rate of interest charged by leading institutions from the borrowers at a flat rate say 10 % throughout money being used or lent to the borrower

A reducing interest rate is the interest rate charged on the left principal amounts as and when the principal amounts are paid off resulting in a reduced interest cost with each instalment of the loan

Method of Calculation

In the case of a flat interest rate, the instalments are calculated based on the initial principal amounts avoiding any decrease in the principal after each instalments payment.

Under reducing interest rate, The interest is calculated based on the principal outstanding on each instalment

Formula

Interest payable per Instalment = (Original loan amount x No. of years x Interest rate p.a.) / Number of instalments.

Interest payable per Instalment = (Original loan amount x No. of years x Interest rate p.a.) / Number of instalments

Rate of Interest Rate

The interest rate under flat loans is usually lower than the reduced-rate loans. However, borrowers may end up paying more interest under a flat rate since the interest cost portion in each instalment reduces under a reduced interest rate. 

The rate of interest is usually lower under reducing the interest rate. However, taking calculations into account you may end up paying low-interest costs under reducing interest rates as compared to flat rate loans.

Easy to Calculate

Flat interest rates are fixed to a specified percentage and thus, It is easy to calculate interest costs under flat rate loans.

Since interest costs changes with every instalment. Interest cost is calculated on the previous outstanding principal amount.

Ease to the borrower

A flat rate is usually not beneficial for regular instalment-paying borrowers since interest costs are high.

Reducing rate loans are more beneficial for the borrower since he is required to pay low-interest costs with each coming interest. 

Also Read: What Is Collateral and How to Get a Collateral-Free Loan?

Conclusion:

We have been through a lot of discussions on flat interest rates and reducing interest rates. At first, we understand the definitions and how they work followed by their respective benefits and at last a difference table. It is worth noting in this regard that flat interest rates are easy to calculate and understand but for a long period project, a flat interest loan may not be beneficial for the borrower and he may end up paying more interest costs. Therefore, it is advisable to evaluate the various alternative and choose the best loan for your business that offers your need and at the same time save a few pennies. It is better to choose to reduce interest rate loans if the funds under loans are of short durations requirements as loans for long period say 10 to 15 years may put your business at the rate of any significant hike in market interest rate hikes since you are not expecting any significant cash inflow from the long term projects.

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FAQs

Q: Under Flat rate of interest and reducing rate of interest, which one is more beneficial for borrowers?

Ans:

Certainly, a Flat rate loan is usually not beneficial for regular instalment-paying borrowers since interest costs are high. Thus, Reducing rate loans are more beneficial for the borrower since he is required to pay low-interest costs with each coming interest. As a consequence, the interest cost of the borrowers may significantly reduce if he or she opts to pay the outstanding loans at a prior period than what was agreed at the time of loan disbursements.

Q: What is a Reducing Interest Rate?

Ans:

A Reducing Interest Rate is the interest rate charged on the left principal amounts as and when the principal amounts are paid off resulting in a reduced interest cost with each instalment of the loan.

Q: What is a Flat Interest Rate?

Ans:

A flat interest rate is the rate of interest charged by leading institutions from the borrowers at a flat rate say 10 % throughout the course of money being used or lent to the borrower.  A flat rate is beneficial to the borrower since his risk is hedged to the extent of the rate of interest and is unaffected by changes in economic factors or a hike in the market interest rate such as the repo rate by the RBI.

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Disclaimer :
The information, product and services provided on this website are provided on an “as is” and “as available” basis without any warranty or representation, express or implied. Khatabook Blogs are meant purely for educational discussion of financial products and services. Khatabook does not make a guarantee that the service will meet your requirements, or that it will be uninterrupted, timely and secure, and that errors, if any, will be corrected. The material and information contained herein is for general information purposes only. Consult a professional before relying on the information to make any legal, financial or business decisions. Use this information strictly at your own risk. Khatabook will not be liable for any false, inaccurate or incomplete information present on the website. Although every effort is made to ensure that the information contained in this website is updated, relevant and accurate, Khatabook makes no guarantees about the completeness, reliability, accuracy, suitability or availability with respect to the website or the information, product, services or related graphics contained on the website for any purpose. Khatabook will not be liable for the website being temporarily unavailable, due to any technical issues or otherwise, beyond its control and for any loss or damage suffered as a result of the use of or access to, or inability to use or access to this website whatsoever.