Flat or Reducing Rate of Interest, Which Option is Best for Your Business?
Before taking out any form of loan, you should carefully consider the interest rate. For most borrowers, it is one of the fundamental elements influencing their decision to pick a lender and apply for a loan. The interest rates also help determine the equivalent monthly installments (EMI), which constitute a legal requirement for your business.
As a result, before beginning with the application process, company owners must grasp what interest rates are relevant, how they are computed, and the related variations. In this post, we will discuss the key distinctions between flat and reducing interest rates and which one is most suited for your business.
Flat Interest Rate
The interest rate is computed on the whole principal amount under the flat interest rate approach. The technique does not take into account principal repayment as the term advances.
Every month, the interest rate and the amount owed stay unchanged. Typically, the flat interest rate is greater than the reducing interest rate. This is due to the fact that the principal amount considered does not decrease overpayments progressively.
Formula to calculate the flat interest rate
Interest due to each installment = (Original loan amount x number of years x annual interest rate) / number of installments
Benefits of flat interest rate
- Effective planning
Because the EMI remains unchanged each month, you can easily plan your monthly finances. This saves you the bother of calculating the EMI each month and planning appropriately.
- Simple Calculation
Because the interest rate is constant, you can easily calculate the flat interest rate on your Personal Loan. In reality, the flat interest rate EMI calculator has simplified the computation process. It simply takes you to provide a few pieces of information, and the calculator will return accurate answers almost immediately.
They address farmers’ critical cash flow needs: Many borrowers in developing nations are farmers who want loans with balloon payments that they can repay after harvesting their crops. When the borrower uses the whole principal amount during the loan period, flat rate calculations equal the actual rate. Flat rate cash
loans are basic and simple to grasp for farmers who are used to dealing with these sorts of transactions.
They facilitate ‘in-kind’ loan transactions: flat-rate loans were established before money and are often used to pay back loans in regular installments.
Disadvantages of flat rate interest
Their meanings are sometimes complicated: “flat rate” is commonly confused with “fixed rate.” A flat rate is a technique for estimating the overall cost of credit, assuming that all payments are completed on time. The provisions of the underlying agreement determine whether or not a rate is changeable.
They may cause a loan portfolio to be undervalued: Furthermore, flat rate computations may somewhat understate the size of an outstanding loan portfolio, giving the illusion of smaller average loan size and a greater yield. Donors and external financiers are drawn to both of these features.
Reducing Rate of Interest
As the name implies, a reducing/diminishing balance rate is an interest rate calculated monthly on the outstanding loan amount. In this arrangement, the EMI comprises both the principal payments and the interest payable on the outstanding loan amount for the
month. The outstanding loan amount is lowered with each EMI payment. As a result, the interest for the following month is determined only on the outstanding loan amount. The formula for calculating diminishing balance interest is as follows:
The formula for calculating reducing balance interest
Interest Due per Instalment = Interest Rate per Instalment * Loan Amount Remaining
Benefits of reducing rate of interest
The key advantage of a falling balance interest rate is that the applicant must pay less interest over time than with a flat interest rate loan.
In the event of a flat rate, however, the loan will be returned in a shorter period of time. Thus, the interest for the months paid in advance does not need to be paid. However, lowering the interest rate would affect the payback period and the interest portion.
Differences Between Flat and Reducing Rate of Interest: –
The mechanism through which the interest rate is determined is the major differentiator. A fixed interest rate is determined on the whole amount, whereas a lowering rate is determined on the outstanding loan on a monthly basis.
- Ease of calculation: The EMIs of a fixed-rate loan is theoretically easier to calculate than those of a diminishing loan. However, you can quickly calculate the latter using an online EMI calculator.
- Tenure: A loan with a decreasing interest rate might have a longer tenure than a fixed interest loan. This gives you greater repayment flexibility.
- EMI amount: While the monthly EMI amount of a flat interest loan remains constant during the loan term, the monthly EMI amount of a reducing rate loan gradually decreases over time as the interest amount decreases with each payment paid.
Choosing between a flat or reducing balance EMI should be done with your financial needs and repayment ability in mind. A fixed EMI often has lower interest rates and a longer payback term. In contrast, a variable EMI has an interest that is fixed throughout the loan term and calculated on the whole loan amount. Because the interest rate varies and is determined by calculating the principal amount outstanding, which decreases over time. A diminishing balance EMI may have lower EMIs and a shorter repayment term.
In a nutshell, reduced interest rates and the ease of calculation associated with flat rates might not be quite as advantageous as initially imagined. Experts feel that, while flat rates are simple to grasp, they can be deceptive when repaying huge debts.
As a result, before applying for a loan, use internet calculators to compare the interest rates on both choices. Make an informed judgment after that.
Flat or Reducing Rate of Interest FAQs:
1. How can a loan with decreasing interest rate give me greater repayment flexibility?
2. What’s the formula to calculate a flat interest rate?
3. What advantages will I have if I opt for reducing the interest rate?
4. What’s the formula for calculating the reducing balance rate?
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