Lenders decide the cost of borrowing for the loan applicant basis the risk-based pricing model. As per the model, the credit behavior of the concern is adjudged and the probable risk of default is computed to determine the interest rate. If the credit profile of the applicant is found to be weak or poor, the individual is likely to be offered loan at a higher rate of interest as there is a higher chance of default by him or her.
In the current regime, bankers and other financing companies employ two types of interest rate structures i.e. flat interest rate and reducing balance interest rate. And both of these rates can be advertised to sell and promote a product. However, the final or effective cost of borrowing for the loan applicant is arrived at by factoring in several parameters such as credit-worthiness, income stream, re-payment history as well as employment status of the concern. Persons without a credit history or those with a low credit score get financing at a higher cost.
Difference between flat rate of interest and reducing balance rate
Under the flat interest rate structure, interest rate is computed on the entire principal amount against the tenure. Say for example: If you have taken a loan of Rs. 1,00,000 for 4 years at a flat interest rate of say 10% then the interest payable will be Rs. 40,000.
The reducing balance rate however computes interest on the outstanding principal amount and takes into account repayments that are being made on a continuous basis. So, the interest herein is calculated on the remaining balance and is charged in accordance with the repayments being serviced against the borrowing.
Interestingly, a reducing balance rate comes to be higher than the flat rate of interest for a loan. By this we mean that a flat rate of interest of say 10% may be equivalent to 15% or higher under the reducing balance rate structure. Further, the final or effective rate of interest in all cases depends on the tenure as well as the loan amount.
What should you go by: Flat or Reducing balance interest rate?
Choosing an interest rate structure or type is not what you can do as the lenders decide the rate of interest computation method. Also, flat interest rate structure doesn't give the effective cost of borrowing for the borrower and its usage for a loan product primarily personal loan is in many a case illogical. Nonetheless, the reducing balance interest rate also called as the effective rate of interest (EIR) decides the actual interest amount you end up paying against the loan after the tenure of your ends.