Planning on applying for a loan soon? Well, before you do, we suggest you familiarize yourself with the two types of interest rate options you might be offered – flat vs. reducing interest rates. This could extend to anything ranging from auto loans to home and personal loans. Read on to find out the difference between the two types Flat Vs Reducing Interest Rates.
Let’s look at the term ‘flat interest rate’ first. This particular term is applied directly to the full principal loan amount. It will remain constant throughout its tenure in spite of the monthly EMIs gradually deducting the original amount.
Example – If you’ve taken a loan of AED 100,000 and the flat rate of interest is 10% per annum for 5 years, then your calculation will be as follows:
Payable interest amount = 100,000 x 0.1 x 5 years = AED 50,000
EMI = 100,000 (Original loan amount) + 50,000 (Interest amount) / 60 months = AED 2,500
Therefore, at the end of the said period, you would have paid AED 150,000.
Now on the other hand, the term ‘reducing interest rates’ or ‘diminishing interest rates’ simply means that the interest rate is calculated each month only on the outstanding loan amount and not the principal amount. So, the EMI to be paid includes the interest for the outstanding amount monthly plus the principal repayment amount.
i.e. – Interest rate per installment x outstanding loan amount = interest payable for each installment
Example – If we take the same aforementioned scenario and replace the Flat rate with Reducing rate, then the calculation in this case will be as follows:
With each payment, the EMI will gradually reduce. In Year 01, your interest will be AED 10,000 however in Year 02, you would have to pay only AED 8,000 as the principal amount is now reduced to AED 80,000. As the years roll by, in Year 05 you would be paying only AED 2,000 interest. At the end of the given period, you would end up shelling out AED 1,30,000 in total. That’s why you will always notice that the reducing interest rates are usually higher than the flat rate for the same loan so that the total payable interest amount in both cases would actually end up very close.
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If you think the math is complicated or you don’t want to waste your time doing lots of calculations for every single loan out there, don’t worry because in BankOnUs, we’ve already done the calculations for you to give you the exact payable/effective interest rate along with the exact EMI amount for every available loan for an easier comparison and more well-informed decision making.
Flat Interest Rates Vs. Reducing Interest Rates
Flat Interest Rates
• The interest rate is calculated on the principal amount.
• Calculating the interest rate is easy
• Flat interest rates are sometimes lower than reducing interest rates
Reducing Interest Rates
• The interest rate is calculated on the outstanding amount each month
• Calculations are a bit complicated
• Reducing interest rates are usually higher than flat interest rates