The basic function of banks and other institutes is to offer loans like personal loans, home loans, auto loans, education loans and more. It is to help borrowers meet many of their needs.
While banks and NBFCs give out loans, their primary source of earning is the interest rate and charges that they get from borrowers.
Two types of interest rates are applied to all loans offered by lenders. These are reducing balance interest rate and fixed rate.
Hence, if you wanted to know the difference between fixed vs floating interest rates, then this post is a must-read.
What is a fixed interest rate?
As the name suggests, the fixed interest rate means that the interest rate on your personal loan or any other will be fixed. Such an interest rate gets calculated on the entire amount throughout the tenor. However, the fixed interest rate is a bit more expensive than reducing balance interest rate.
Suppose if you take a personal loan at 13%, then the rate of interest will remain the same during the entire tenor. The biggest benefit of this kind of interest rate is that you will be in complete control of your repayments. Yes, since the interest rate is fixed, you can ensure to pay only fixed EMI per month.
What is reducing balance interest rate?
Reducing balance interest rate means that the interest rate gets calculated each month on the outstanding loan amount. This method means that the EMI is having interest payable for the outstanding loan money along with the principal repayment. When you pay the EMI each month, then the outstanding loan amount decreases. Thus, the next month’s interest rate is computed only on the basis of the outstanding loan amount.
Suppose if you take a loan of Rs.1 lakh at reducing balance interest rate of 10% for 5 years, then with every repayment, your EMI will keep on reducing. The interest payment will be Rs.10,000 in 1st year. But it will be Rs.8,000 on the reduced outstanding of Rs.80,000 in the 2nd year. This way, it will continue until the end of the tenor, and you will end up paying only Rs.2,000 as interest.
The reducing balance interest rate is generally used for mortgage, housing and property loans, along with credit cards and overdraft facilities. Under this system, you only need to worry about paying interest on the outstanding amount. The interest rates for such loans are similar to ones being used for Savings Accounts and Fixed Deposits. It is known as the Effective Interest Rate.
Differences between flat and reducing balance interest rate
- In the flat rate system, the interest rate gets calculated on the loan’s principal amount. On the other hand, the personal loan interest rate is measured on the outstanding loan money on a monthly basis in the reducing balance interest rate system.
- Flat interest rates are considered lower than the reducing balance interest rate.
- Flat interest rate calculation is easy when compared to reducing balance interest rate in which calculations are a bit complex.
- Overall, the reducing balance interest rate is considered better than the conventional flat interest rate methods.
When you are availing the loan, your intention should be checking if your lender is offering the reducing balance interest rate or a flat rate. It will help you be in a better position to know if you will pay more via repayments or not.