As you explore available loan options, you’ll likely come across two common interest types: fixed interest rate and discounted interest rate. These terms may seem technical, but understanding the difference between them can help you choose a loan that truly fits your needs and financial situation.
At first glance, the two types of interest may seem similar; after all, the idea is to borrow money and pay it back with said interest. However, the way interest is calculated varies widely and this difference can have a big impact on your total repayment amount and even your monthly budget.
The main difference between a fixed interest rate and a discount interest rate is that a flat rate gives you a predictable monthly payment because interest is calculated on the entire principal amount at the start of the loan term. Whereas a sliding scale interest rate works on a dynamic structure, where interest is calculated on the outstanding balance after each payment. This means your interest charges decrease over time, potentially saving you money in the long run.
So which option is best for you? Let’s look at the difference between fixed and discounted interest rates to help you understand which one best suits your needs.
What is the flat rate interest rate?
A flat rate is a type of interest rate that remains constant over the life of the loan. This interest rate is calculated on the entire principal amount from the start of the loan term. This means that regardless of repayments made over time, the interest amount remains the same throughout the life of the loan.
When a borrower obtains a fixed interest rate loan, a repayment schedule is created, which includes the Equated Monthly Installments (EMI) that the borrower has to pay. Since the interest rate is based on the total loan amount, this structure provides predictability in the repayment process, allowing borrowers to manage their finances accordingly.
Advantages of Flat Interest Rate
Opting for a flat interest rate on personal loans has several advantages, making it an attractive choice for borrowers. These include:
1. Simplified EMI Calculation
One of the main advantages of a flat rate interest rate is the simplicity it offers in calculating EMIs. With a fixed interest rate applied to the total principal amount over the life of the loan, borrowers can easily estimate their monthly payments. This simple calculation can help make the reimbursement process more manageable.
2. Predictable financial planning
A fixed interest rate contributes to better financial planning. Since EMIs remain constant, borrowers can accurately plan their monthly financial obligations. This predictability allows individuals to budget effectively, ensuring they do not exceed their repayment capacity. Knowing exactly how much to allocate each month helps you maintain a stable financial situation.
3. Advantages of prepayment
Another benefit of a fixed interest rate is the ability of borrowers to reduce their EMIs through early repayments. If you decide to repay part of your principal early, the new EMI will reflect this change from the next payment cycle. The fixed interest being based on the amount of the capital, any reduction in the capital will subsequently reduce your monthly payments, thus reducing your budget.
4. Clarity and transparency
Flat interest rate calculations are generally easier to understand, which can be especially beneficial to new borrowers. This method minimizes confusion about how interest is applied, making it accessible to all types of borrowers.
What is interest rate reduction?
The declining interest rate is a method of calculating interest on a loan based on the remaining principal balance. When you make your monthly EMI payments, part of your payment goes towards reducing the principal amount. Since interest is calculated on this diminished amount, your interest payments decrease over time.
Benefits of interest rate reduction
Here are some of the benefits of interest rate reduction:
1. Decreasing amount of interest over time
With a sliding scale interest rate, the interest calculation is based on the remaining principal balance rather than the original loan amount. As the loan principal decreases with each EMI, the interest payable also decreases with time. This gradual reduction helps reduce the financial burden, making the loan more affordable in the long term.
2. Lower loan cost
Lowering interest rates can lead to substantial savings. Unlike flat interest rate loans, where interest is calculated on the entire loan amount, the declining balance method only considers the outstanding balance, resulting in a reduction in total interest charges. Ultimately, this makes the loan more profitable because you only pay interest on the outstanding principal.
3. Potential for shorter loan duration
Since the monthly payment can decrease over time with each payment, borrowers could potentially pay off their loan more quickly. This benefit is particularly attractive to those who want to settle their debts sooner and minimize the length of time they are tied to loan obligations.
Difference between fixed interest rate and reduced interest rate
When you opt for a loan, it is important to choose the interest rate that suits you because it directly impacts the overall repayment cost. The two main types of interest rates, fixed interest rate and reducing interest rate, differ significantly in the way the interest amount is calculated, influencing EMIs and loan tenure. Here’s a breakdown to help you understand the difference between fixed and discounted interest rates.
1. Interest rate calculation method
The main difference between fixed and declining interest rates is how the interest is calculated.
Flat interest rate: Interest is calculated on the total loan amount (capital) at the start of the loan term. This means that the interest rate remains fixed throughout the life of the loan and does not decrease even when you repay part of the principal.
Reduce the interest rate: Interest is calculated only on the unpaid principal balance. As you make payments, the principal decreases each month, reducing the interest amount and hence the EMIs over time.
The calculation of EMIs varies for each type of interest rate:
Flat Interest Rate Formula:
Or:
P = Principal amount
I = Interest rate
T = Loan duration in years
This formula is simpler as it requires only the principal amount of the loan, which allows for simple calculation of the EMI.
Interest rate reduction formula:
This formula is slightly more complex, because it takes into account the outstanding principal balance, recalculating the interest on the remaining amount each month.
2. Reimbursement flexibility
Flat Interest Rate Loans: Borrowers may benefit from a stable EMI amount throughout the loan tenure, but may not benefit from reduced costs during the loan tenure.
Reduce interest rate loans: These offer more flexibility. Since interest decreases as the outstanding principal decreases, these loans can be more profitable, especially over an extended repayment period.
3. EMI Payments
Flat interest rate: The EMI amount remains constant throughout the loan tenure. This predictability can be beneficial for those who prefer a fixed monthly payment without fluctuations.
Reduce the interest rate: The EMI amount decreases with time. Since interest is calculated only on the remaining principal, borrowers may see a gradual decline in their EMIs, which can ease the repayment burden over time.
What is the best fixed or reducing interest rate?
Choosing between fixed or reduced interest rates depends on your budget and repayment preferences. If you prefer predictability and fixed monthly payments, a flat interest rate may suit you better. However, if you’re looking for a potentially more economical option, a reduced interest rate could be beneficial.
Conclusion
When it comes to choosing between a flat rate and a reduced rate, it’s essential to understand your financial priorities. A fixed interest rate provides predictability with fixed EMIs, which can be ideal for short-term loans or for those looking for stable payments. On the other hand, a declining interest rate is often more economical in the long run as it calculates interest on the decreasing principal amount, resulting in lower EMIs over time.
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Frequently Asked Questions
What type of interest rate reduces overall costs?
Usually, a lower interest rate results in lower overall costs because interest is calculated only on the outstanding loan balance. With a flat interest rate, interest is calculated on the total principal amount.
What is the difference between Fixed Interest Rates and EMI Reducer Interest Rates?
With a flat rate interest rate, the EMI amount remains the same throughout the loan tenure. On the other hand, with a decreasing interest rate, the EMI decreases over time as the outstanding principal decreases, making it easier to manage for long-term borrowers.
How do I decide which type of fixed or reducing interest rate is best for me?
To choose between a fixed or reduced interest rate, consider the length of your loan, your repayment capacity and the flexibility of your budget. If you prefer stable monthly payments, a flat rate may be better. If you want to save on interest and can manage the EMI change, a reduced rate may be more beneficial.
Is a declining interest rate the same as a floating interest rate?
No, a declining interest rate is different from a floating (or variable) interest rate. A declining rate calculates interest on the unpaid principal each month, while a floating rate fluctuates based on market conditions or central bank rates, impacting your EMI based on economic factors.
What type of interest is best for personal loans: fixed or decreasing?
Personal loans generally have fixed interest rates and borrowers may prefer the fixed structure of the EMI. However, if the lender offers a reduced interest rate, you may be able to save more on interest.