Understanding Flat Rate vs Reducing Balance Rate
When taking a loan, understanding how interest is calculated is crucial. The same advertised rate can mean vastly different costs depending on whether it's a flat rate or reducing balance rate.
What is Flat Rate Interest?
Flat rate (also called simple interest rate) calculates interest on the original loan amount throughout the tenure, regardless of how much principal you've already repaid.
EMI = (Principal + Total Interest) / Number of Months
Example: ₹5,00,000 at 10% flat for 3 years:
- Interest = 5,00,000 × 10% × 3 = ₹1,50,000
- EMI = (5,00,000 + 1,50,000) / 36 = ₹18,056
What is Reducing Balance Rate?
Reducing balance rate (diminishing rate) calculates interest only on the outstanding principal. As you pay EMIs, principal reduces, so interest also reduces.
where r = monthly rate, n = months
Example: ₹5,00,000 at 18% reducing for 3 years:
- Monthly rate = 18%/12 = 1.5%
- EMI = ₹18,076 (calculated using formula)
- Total Interest ≈ ₹1,50,736
Conversion Formula
| Conversion | Formula |
|---|---|
| Flat to Reducing | Reducing = Flat × 2 × n / (n+1) × 12 |
| Reducing to Flat | Flat = Reducing × (n+1) / (2 × n × 12) |
| Quick Approximation | Reducing ≈ Flat × 1.8 to 2.0 |
Where n = tenure in months. The multiplier varies from ~1.85 for short tenures to ~2.0 for longer tenures.
Quick Reference: Flat to Reducing Conversion
| Flat Rate | 1 Year | 2 Years | 3 Years | 5 Years |
|---|---|---|---|---|
| 5% | 9.2% | 9.6% | 9.7% | 9.8% |
| 7% | 12.9% | 13.4% | 13.6% | 13.7% |
| 10% | 18.5% | 19.2% | 19.5% | 19.7% |
| 12% | 22.2% | 23.0% | 23.4% | 23.6% |
| 15% | 27.7% | 28.8% | 29.3% | 29.6% |
Who Uses Which Rate?
| Loan Type | Rate Type |
|---|---|
| Home Loans (Banks) | Reducing |
| Car Loans (Banks) | Reducing |
| Personal Loans (NBFCs) | Often Flat |
| Two-Wheeler Loans | Usually Flat |
| Credit Card EMI | Flat (per month) |
| Consumer Durable Loans | Usually Flat |
Frequently Asked Questions (FAQs)
Is 10% flat rate equal to 10% reducing rate?
No! 10% flat rate is approximately equal to 18-20% reducing rate. This means a loan at 10% flat is almost double the cost of a 10% reducing rate loan. Always compare the total interest payable.
Why do some lenders use flat rate?
Flat rates appear lower and are easier to market. "7% interest" sounds better than "13% interest" even if they cost the same. RBI requires disclosure of APR (Annual Percentage Rate) which is the effective reducing rate.
How can I compare two loan offers?
Convert both to the same rate type (preferably reducing) or simply compare the total interest payable. A lower rate number doesn't always mean a cheaper loan.
Can I negotiate flat rate to reducing rate?
Most lenders have fixed policies. However, you can ask for the equivalent reducing rate for comparison. Banks typically use reducing rate while NBFCs and dealers often use flat rate.
Does prepayment work differently for flat vs reducing?
For reducing balance loans, prepayment directly reduces principal and future interest. For flat rate loans, interest is pre-calculated, so you may not save proportionally on prepayment. Check foreclosure terms before taking the loan.