Factors to Know before Getting Personal Loan: Flat Rate vs. Reducing Balance Rate

Personal Loans are all-purpose, unsecured loans that can be raised for an array of needs. There are no restrictions attached, whatsoever on the end use of the funds; and thus this credit product extends a lot of flexibility to the borrower. 

You can choose the loan amount, tenure, and monthly repayment according to your financial health and cash needs. It is commonplace to apply for Personal Loans owing to urgent medical, personal, or business needs. Well, this ease of borrowing comes wrapped with a higher risk for the lender. This is why getting a Personal Loan is more expensive than securing a Car Loan or Auto Loan. The lenders charge a higher rate of interest for the additional risk on a Personal Loan.

Currently, Personal Loan interest rate in India range anywhere from 11% to 24% p.a. The effective rate depends entirely on the credit profile of the borrower as well as the lender’s policy. For example: SBI Personal Loans are available between 11% – 17.05% p.a. It is always advisable to negotiate for the best possible rate so that you can save some bucks on the repayment of the loan

Interest Rate of a Personal Loan is one of the important factors to ponder over before availing a loan—be it an HDFC or IDFC First Personal Loan. Let’s take a complete overview on interest rates and understand how you can save simply by choosing a more attractive rate.

Interest Rate vs. APR

Interest Rate is basically a charge (in percentage) you pay on the principal amount borrowed as a Loan. However, the annual rate of interest on your loan is not equivalent to its annual percentage rate, or APR. 

Let’s take an example: A Personal Loan for Rs 12 Lakh at 10% percent effective rate of interest for 1 year would cost you Rs 1.2 Lakh on interest annually.

However, the APR would not be the same as the annual Interest burden of the loan. The APR involves interest expense as well as the associated fees and charges you spend for the loan processing. The other fees could be loan processing fees, discounts, or penalties involved. Thus APR of the loan is higher than the interest paid on loan.

Types of Interest Rate: Flat rate vs. Reducing Balance rate

As important it is to have a clear understanding on the overall cost of the loan as is to understand the calculation of loan EMI.

EMI is equated monthly instalment for your loan. That is, in the example shared above, the borrower will pay an EMI of Rs 30000 every month for 5 years to repay the loan. This flat repayment is evaluated basis the flat rate of 10% p.a. on Rs 12 Lakh loan for 5 years.

However, the same loan would cost you lesser if the calculation for EMI is based on the reducing balance rate. In the reducing balance method, every month interest is calculated on the outstanding principal amount. After every monthly repayment, the outstanding principal balance reduces, and thus the next month’s EMI reduces eventually. The reducing balance rate is also known as the diminishing rate of interest.

Formula for calculating EMI using reducing balance interest rate

EMI = Interest Rate X Remaining Loan Amount

For further understanding, let’s compare the EMIs based on a fixed rate as well as reducing rate for the Personal Loan with the following parameters:

Personal Loan Parameters
Loan Amount: Rs 12,00,000
Loan Term: 5 years
EMI Start Date: 30-June-2019
Interest Rates: Flat Rate: 10.00 % p.a.
Reducing Rate: 14.00 % p.a.

Flat Rate vs. Reducing Rate

Flat Rate – 10.00% Reducing Balance Rate – 14.00%
Loan Amount = 12,00,000 Loan Amount = 12,00,000
EMI = 30,000 EMI = 27,922
Total Interest = 6,00,000 Total Interest = 4,75,314
Total Payments = 18,00,000 Total Payments = 16,75,314
Periods = 60 months Periods = 60 months
Last EMI Date = 30-May-2024 Last EMI Date = 30-May-2024

As you can see in the given example, one can save substantially on the reducing balance rate. Thus, it recommended to do all the calculations well before signing the loan agreement. The higher reducing balance may eventually be more affordable than the low flat rate on your loan.

In case the calculations part is overwhelming for you, consider using an online EMI calculator for the same. All you need to do is fill the loan parameters, and the EMI burden would be instantly calculated. The calculator is free of cost, and it is almost hassle free to access the loan EMI calculations online.

Herein, it is also important to note that your bank may not offer you Personal Loan on reducing rate. Most banks and NBFCs offer Personal Loans on fixed rate only. The reducing rate method is particularly offered for high ticket secured loans such as Home Loans, LAP, overdraft facilities, and Credit Card advances.

While some similar products such as Bajaj Finserv Flexi Term Loan offers you parallel benefits. In all likelihood, if you intend to repay your loan before tenure, reducing interest can greatly help you save on the interest of the loan.

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Author: Eddy

Eddy is the editorial columnist in Business Fundas, and oversees partner relationships. He posts articles of partners on various topics related to strategy, marketing, supply chain, technology management, social media, e-business, finance, economics and operations management. The articles posted are copyrighted under a Creative Commons unported license 4.0. To contact him, please direct your emails to editor.webposts@gmail.com.