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In Simplier Terms

‘X% p.a.’ Flat Interest Rate is not same as ‘X% p.a.’ Reducing Balance Interest Rate (also referred to as Diminishing Balance Interest Rate or Effective Interest Rate).

Flat Interest Rate means Interest is calculated on the full original loan amount for the whole term without taking into consideration that periodic payments reduce the amount loaned. In other words, Flat Rate of Interest basically means that interest is charged on full amount of loan throughout its loan tenure.

For example, if you take a loan of Rs 1, 00,000 with a flat rate of interest of 10% p.a. for 5 years, then you would pay: Rs 20,000 (principal repayment @ 1, 00,000 / 5) + Rs 10,000 (interest @10% of 1, 00,000) = Rs 30,000 every year or Rs 2,500 per month. Over the entire period, you would actually be paying Rs. 1, 50,000 (2,500 * 12* 5). Therefore, in this example, the monthly EMI of Rs. 2,500 converts to an Effective Interest Rate of 17.27% p.a.

In Reducing method, interest is calculated every month on the outstanding loan balance. EMI payment every month contains interest payable for the outstanding loan amount for the month plus principal repayment. On every EMI payment, outstanding loan amount reduces by the amount of principal repayment.

For example, if you take a loan of Rs 1, 00,000 with a reducing rate of interest of 10% p.a. for 5 years, then your EMI amount would reduce with every repayment. In the first year, you would pay Rs 10, 000 as interest; in the second year you would pay Rs. 8,000 on a reduced principal of Rs. 80,000 and so on, till the last year, you would pay only Rs. 2,000 as interest. Unlike the fixed rate method, you would end up paying Rs. 1.3 lakh instead of Rs. 1.5 lakh.

Diminishing Balance Interest Rate is better from the perspective that it is more transparent and signifies the “Effective Interest Rate”. Flat Interest Rate is generally misleading and is often used to entice customers with too good to resist offers. If you are offered 5-year loan at only 10% Interest Rate, it might sound great but may be on little digging you will realize that Interest Rate is quoted on Flat basis and the Effective Interest Rate (i.e. Diminishing Balance Interest Rate) is actually 17.27%.

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