Flat interest rate vs reducing interest rate in 2024
When considering taking out a loan or investing your money, you’ll often encounter two different types of interest rates: flat and reducing.
These terms refer to how Interest is calculated and can significantly impact the total cost of a loan or the return on an investment.
This guide will explore the differences between flat and reducing interest rates to help you make informed financial decisions.
Flat Interest Rate
Definition: A flat or simple interest rate is calculated on the entire principal amount through out the loan tenure. In other words, you pay Interest on the original loan amount (principal) from start to finish, regardless of how much of the principal you’ve already repaid.
Calculation: The interest amount remains constant throughout the loan term, making it easy to calculate. You can find it by multiplying the principal amount by the interest rate & the loan tenure (in years).
Impact: Loans with flat interest rates tend to have higher monthly EMIs (Equated Monthly Installments) because you’re paying Interest on the entire principal balance, even as you make repayments. This can make them costlier over the long term.
Common Examples: Personal, education, and car loans are often advertised with flat interest rates.
Reducing Interest Rate
Definition: A reducing interest rate, or a diminishing balance or compound interest rate, is calculated on the outstanding loan balance. As you make payments, the Interest is applied to the remaining principal, reducing the interest portion over time.
Calculation: The interest amount varies with each payment. It is calculated by multiplying the remaining principal by the interest rate for the given period.
Impact: Loans with reduced interest rates generally lower overall interest costs because you’re effectively repaying a smaller portion of the principal with each payment.
Common Examples: Home loans, most personal loans, and car loans use reducing interest rates.
Key Differences
Interest Calculation: The primary difference lies in how Interest is calculated. Flat Interest is based on the original principal amount while reducing Interest is based on the outstanding balance.
Monthly Payments: With a flat interest rate, monthly payments remain constant throughout the loan tenure. In contrast, reducing interest rates decreases monthly payments as the principal balance reduces.
Total Interest Paid: Loans with flat interest rates tend to result in higher total interest payments over the loan term than reducing interest rates.
Loan Cost: Loans with flat interest rates may seem attractive due to their lower initial EMIs, but they can be more expensive in the long run compared to loans with reduced interest rates.
Conclusion
Understanding the difference between flat and reducing interest rates is essential when making financial decisions involving loans or investments.
The choice between the two depends on your specific needs and financial goals. While flat interest rates may offer lower initial monthly payments, loans with reduced interest rates are often more cost-effective over the long term.
When comparing loans or investments, consider the interest rate type carefully, as it can significantly impact your overall financial well-being.
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