Well to explain it simply, when you take a loan for a particular tenor, you need to not only repay the principal amount within that tenor but also pay the interest on the loan. How the bank/ financier calculate the interest is very important. ‘X% p.a.’ charged on Flat basis is certainly not same as ‘X% p.a.’ charged on Reducing / Diminishing Balance (also referred to as Effective Interest Rate).

Flat Rate of Interest basically means that interest is charged on the full amount of the loan throughout its entire loan tenor. Thus the flat rate does not take account of the fact that periodic repayments, which include both interest and principal, gradually reduce the outstanding loan amount. Consequently the Effective Interest Rate is considerably higher than the nominal Flat Rate initially quoted.

For instance: If you take a loan of Rs 100,000 with a flat rate of interest of 10% p.a. for 5 years, then you would pay Rs 20,000 (principal repayment @ 100,000 / 5) + Rs 10,000 (interest @10% of 100,000) = Rs 30,000 every year or Rs 2,500 per month. Over the tenure of the loan, you would end up paying Rs 150,000 (2,500 * 12 * 5). Thus in this example, monthly EMI of Rs 2,500 translates to an Effective Interest Rate of 17.27% p.a.

What's Reducing / Diminishing Balance Rate?
In Reducing / Diminishing Balance Rate method, interest is calculated every month on the outstanding loan balance as reduced by the principal repayment every month. EMI payment every month contains interest payable for the outstanding loan amount for the month plus principal repayment. On every EMI payment, outstanding loan amount reduces by the amount of principal repayment. Thus interest for next month is calculated only on the outstanding loan amount as reduced by the principal repayment this month.

For example, if instead of 10% p.a. flat rate (in the above example), interest is charged at 10% p.a. reducing balance rate, EMI amount would be Rs 2,124.70 (please see earlier post on EMI Calculator). You would pay Rs 833.33 as interest in the first month and Rs 1,291.37 (2,124.70 – 833.33) would be Principal Repayment. For next month interest will be charged only on reduced principal, i.e. 100,000 less 1,291.37 = 98,708.63. Interest for second month would be Rs 822.57 (98,708.63 * 10% / 12) and principal repayment would be Rs 1,302.13 (2,124.70 – 822.57). Thus over the tenure of the loan, you would end up paying Rs 127,482 (2,124.70 * 12 * 5).

Effective Interest Rate for a given Flat Rate of Interest
If you just got a home loan or auto loan offer at flat rate of interest which looks attractive, before jumping at the same, please see the actual Effective Interest Rate or Diminishing Balance Rate you are being quoted. Use the link below to download an excel sheet to calculate Effective Interest Rate for a given Flat Interest Rate. This excel sheet not only converts Flat Interest Rate to Effective Interest Rate (or Diminishing Balance Interest Rate or Reducing Balance Interest Rate or Annualized Percentage Rate), but also calculates the EMI as per Flat Interest Rate and EMI as per Reducing / Diminishing Balance Interest Rate for the quoted rate

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