Flat Rate vs Reducing Balance Method: Learn How Bank Loans Work
5 min read | 4 months ago
Imagine you’re planning a big family event, like a wedding. You’ve decided a personal loan is the best way to manage the expenses, but the moment you sit down with a bank representative, you’re presented with two unfamiliar terms: flat rate and reducing balance. Suddenly, you realise that choosing the right loan could save you more money for the honeymoon or the wedding attire.
Or let’s say you want to invest in a new skill, maybe a culinary course abroad. You’ve got everything planned, but when it comes to financing, the loan options leave you puzzled. Would you prefer a flat rate, where the interest is fixed or a reducing balance method, which adjusts as you repay?
Understanding these terms might not sound exciting, but it’s the key to making the most out of your personal loan. So, let’s explore how these two methods work and see which one aligns best with your financial goals.
Flat Interest Rate Method
Meaning: With the flat rate method, interest is calculated on the entire principal amount throughout the loan term, regardless of how much has been repaid.
Formula: Interest = (Principal x Rate x Tenure) / Number of Instalments
This ensures that the interest payment remains the same over time.
Example: For a ₹1,00,000 loan with a flat interest rate of 10% over 3 years, annual interest remains ₹10,000, leading to a total interest of ₹30,000.
Benefits:
1.Simple calculation, making it easy to understand.
2.Predictable fixed monthly payments help with budgeting.
3.No fluctuations in interest, ensuring clarity of total cost upfront.
Reducing Balance Method
Meaning: The reducing balance method calculates interest on the outstanding loan amount, which decreases as repayments are made.
Formula: Interest = (Principal Remaining x Rate) / Instalments
This method reduces the interest payable over time as the principal diminishes.
Example: With a ₹1,00,000 loan at 10% over 3 years, each repayment reduces the principal, so interest decreases monthly, resulting in lower overall interest costs.
Benefits:
1.Interest savings as payments reduce principal.
2.Ideal for long-term loans, lowering total interest over time.
3.Supports early repayment without high interest, lowering total loan cost.
Get personal loans at the best terms with Unity Small Finance Bank
| Aspect | Secured Loans | Unsecured Loans |
|---|---|---|
| Interest Calculation | Calculated on the full principal amount for the entire loan term | Calculated on the remaining principal, which decreases with each repayment |
| Monthly Payments | Fixed, as interest remains constant throughout | Variable, as the interest reduces as the principal decreases |
| Total Interest Paid | Higher, since it’s based on the initial principal regardless of repayments | Lower, due to interest only on the outstanding principal balance |
| Suitability | Suitable for short-term loans or when predictability is needed for budgeting | Ideal for long-term loans, offering savings as the loan term progresses |
| Clarity | Easier to understand due to fixed costs but may not reflect true cost over time | Provides a clearer reflection of actual costs over time as the balance decreases |
| Cost-effectiveness | Less cost-effective over time, especially for long-term loans | More cost-effective, particularly for longer durations due to reduced interest |
Which Should You Choose?
The choice between a flat rate and reducing balance method depends on your financial goals and loan preferences.
If you prioritise simplicity and need fixed monthly payments for easier budgeting, the flat rate method might suit you better. It provides a clear and predictable repayment structure, which can help you plan your finances without worrying about fluctuations in EMIs.
On the other hand, if you’re focused on minimising interest costs and plan to hold the loan for a longer period, the reducing balance method could be more advantageous. Since this method calculates interest on the decreasing principal, it often results in lower overall interest costs, making it a cost-effective choice for long-term loans.
Ultimately, consider your budget, loan term and financial priorities. For those who intend to pay off their loan early or want to save on interest over time, the reducing balance method might offer better savings. But if you need simplicity and fixed payments, a flat rate could provide the clarity you need.
Summing up
Whenever you consider taking a loan, whether it’s a personal loan from Unity Small Finance Bank or a home loan, be sure to evaluate the details of both the flat rate and reducing balance methods. These choices can significantly affect your total repayment and monthly budget. By selecting the method that best fits your needs, you can align your loan with your financial goals.
About Unity Small Finance Bank
Unity Small Finance Bank is committed to making banking simpler and more accessible for everyone. Our services include Savings Account, NRI account, Current Account, Fixed Deposits, and Personal Loans offering flexible tenures and attractive interest rates. We also offer financing options like MSME Loans and Microfinance to support businesses and underserved communities. Learn more about Unity Small Finance Bank here.
