Flat vs. Reducing balance interest rate.
Flat vs Reducing balance interest rate:
Many times specifically when you are taking personal loan, the financial institution offers flat interest rate instead of reducing balance. There is a huge difference between two. Here is the illustration:
Flat interest rate, as the term implies, means an interest rate that is calculated on the full amount of the loan throughout its tenure without considering that monthly EMIs gradually reduce the principal amount. As a result, the Effective Interest Rate is noticeably higher than the nominal Flat Rate quoted in the beginning. The formula of calculating fixed rate of interest is –
Interest Payable per Instalment = (Original Loan Amount * No. of Years * Interest Rate p.a.) / Number of Instalments
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.