Getting a loan is very easy these days. Banks offer different types of loans such as Personal Loan, Home Loan, and Car Loan to help you meet your diversified individual requirements. Not only getting a loan is easy, paying it back is also equally affordable. You can pay off your principal as well as interest component on the principal with the help of equated monthly installments (EMIs). When you apply for a loan and your loan application is approved, your bank may apply two methods of calculating interest payable on the principal amount; they either charge fixed rate method or a reducing balance method to calculate interest. Fixed rate and reducing balance rate are two common types interest rates charged on your loans.
Know about fixed and reducing balance interest rates
In fixed or flat rates, banks calculate interest keeping the outstanding amount fixed throughout the whole loan tenure. This method is normally used to calculate interest payable on personal loans. Interest is calculated on the full amount of the loan for the entire tenure without taking into account the fact that the monthly EMIs gradually reduce the principal amount of the loan.
But in reducing balance method, interest rate is calculated based on the reduced outstanding loan amount. Instead of charging a fixed and equal amount of interest every year or month, the reducing balance method charges interest on the remaining balance of your loan. Normally, banks use this method of calculation to calculate interest payable on property loans. After every EMI payment you make, your original loan amount gets reduced and interest for the next month is calculated only on the reduced outstanding amount. So, your principal loan amount will not be static in this method. It gradually decreases. In reducing balance method, your EMIs will include interest payable for the outstanding loan amount for the month along with repayment towards the principal amount. You can calculate reducing balance monthly loan EMIs by using an EMI Calculator and putting the following information in it - the rate of Interest, loan amount, loan tenure and whether you choose annual, monthly or daily reducing balance for the calculation. Once, you put all these details, the calculator will instantly reveal the amount of monthly EMIs.
Difference between fixed and reducing balance methods of interest calculation
The two methods of interest calculation, fixed rate and reducing balance rate, function differently. Mentioned below are some of the difference between both:
- In the fixed rate method, banks calculate interest on your monthly EMIs keeping the outstanding amount fixed throughout the entire tenure of your loan. But, in the reducing balance method, the interest rate on your monthly EMIs is calculated based on the reduced principal loan amount.
- It is easy to calculate flat interest rate compared to reducing balance interest rate.
- With the reducing balance method, you will pay less interest than you would pay with a fixed rate scheme.
- The reducing balance method is a better idea than flat rate method, if your monthly income is expected to fall down.
Which method of interest calculation should I choose for loan EMIs?
No matter, which method you choose to pay interest on your loans, it is important you know about these two methods of deducting interest on loans. Also, you should have a clear idea about which method your bank is using to calculate interest on your loan. Normally, banks offer very attractive interest rates on fixed rate loans. But, don’t always look at the interest rate part of your loan. You should also consider the method of calculating interest on it. Many borrowers don’t prefer to go for flat rate loan EMIs because even if you pay off your loan, your interest amount does not reduce. But, in case of a reducing balance interest rate loan EMI scheme, your interest amount goes down as you make payment towards your principal amount. But, the only problem you may face with the reducing balance method is that you may end up paying higher payments in the initial period of loan repayment.
