Reducing Balance Or Flat Method; Why They Are Important When Taking A Loan?

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Nitin got a call from an executive of an NBFC for a personal loan. He was rather surprised when he was told that the interest rate was at 8 per cent per annum. On further clarification, he was given to understand that it was a flat rate of interest and not on reducing balance.

 Reducing Balance Or Flat Method; Why They Are Important When Taking A Loan?
Some lenders still quote flat rate of interest, which is not really correct. If I take a personal loan, my EMI begins immediately, and I am paying a part of the principal, so why should I be told a flat rate. This is because the interest rate on a flat basis is always lower than on a reducing balance and it is easy to sell based on a flat rate.

Difference between reducing balance and flat method of interest rate calculation?

The best way to explain the difference between the two is through an example. Let us say that Nitin wants to take a personal loan of Rs 1 lakh at a flat interest rate of 10% for 1 year.

His simple interest in this case would be Rs 10,000 which would be added to the principal of Rs 1 lakh. So, he has to pay Rs 1,10,000 after 1 year.

If you divide the amount by 12 months, than he would have to pay Rs 9,166 every month.

Now, if you take the same principal and interest on reducing balance, than he would have to pay just Rs 105,499, which translates to Rs 8791 per month. This is a remarkable difference in the EMI.

It is always a good idea to take money on reducing balance. Generally, there will be a few per centage points difference between the two, with reducing balance being higher than a flat rate of interest.

There are many EMI calculators these days, which allow you to calculate your EMI. It is best to do a comparison and understand the finer nuances. Over a tenure of 5 years, a small difference in the EMI can make a big difference.

We suggest that you make enquiries with bank officials or lenders, and calculate the EMI based on both methods.

Most of the Non Banking Financial Institutions and the micro finance companies, use the flat method. On the other hand, banks almost always use the

Read more about: emi, interest
Story first published: Monday, March 28, 2016, 8:40 [IST]
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