At any given point in time, an X% flat rate is always more expensive than an X% annual reducing balance rate. The effective total interest paid out is also influenced by the time periods the reducing balance is recalculated, which could be monthly, daily, yearly, quaterly or half yearly. These time periods are known as rests. At a flat rate , the interest rates are calculated keeping the outstanding amount (i.e. the amount on which interest is calculated) constant throughout the loan tenure while in a reducing balance loan the interest rate is recalculated on a periodic basis based on the reducing outstanding loan amount.
When you take a loan banks can calculate interest rates in either at a flat rate or at a reducing balance rate.
At a flat rate , the interest rates are calculated keeping the outstanding amount (i.e. the amount on which interest is calculated) constant throughout the loan tenure while in a reducing balance loan the interest rate is recalculated on a periodic basis based on the reducing outstanding loan amount.
At any given point in time, an X% flat rate is always more expensive than an X% annual reducing balance rate. The effective total interest paid out is also influenced by the time periods the reducing balance is recalculated, which could be monthly, daily, yearly, quaterly or half yearly. These time periods are known as rests.
To understand the difference in the impact between a flat rate loan amount and a reducing balance loan amount, let’s picture this. Gayathri took a 5 L loan at a flat interest rate of 12.75% and felt she had an excellent deal compared to her friend Sanjana who also took a 5 L loan around the same time at a reducing balance rate of 13%.
The truth is that the effective interest paid out by Gayathri was much higher. She paid out an EMI of 6365 every month while Sanjana paid out an EMI of 6326. The total interest paid out by Gayathri amounted to Rs. 645610 while Sanjana paid a lesser total interest of 638718.
Banks generally quote an “annualized” interest rate, but remember that interest rates can be deceptive unless you figure out how they are defined. You can easily calculate the total amount of interest that you will pay for each offer by multiplying your EMI into the number of monthly installments and subtracting the loan amount from this figure. You can then easily identify which loan is the most cost effective for you. Remember to account for any upfront fees (eg. processing fee) while comparing two loans.
In summary, the key to understanding your loan offers from multiple banks is to calculate the total amount of interest and fees you would pay for each offer and zero in on the offer that gives you the least total interest outflow.