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Flat vs Reducing Balance – Which Type of Personal Loan Interest Rate Should You Choose?

Highlights

  • Personal loans can be offered at the same rate of interest yet the repayment can vary
  • This happens due to the type of personal loan interest rate - flat vs reducing balance - you choose. Let’s check out here the better of the two

While applying for a personal loan, two people can get the same rate of interest. Yet, there can be differences in their overall repayment despite both of them choosing the same loan amount and tenure. The difference is created by none other than the type of personal loan interest rate you choose to service the debt. Yes, personal loans are offered either on a flat or a reducing balance basis. The repayment on a flat rate will differ from the reducing balance. If you choose the interest rate type randomly, you might end up paying much more to the lender and curse yourself on realising your mistake later on. So, you should understand the functioning of both flat and reducing balance interest rates before choosing from them. We are here to help you understand the functioning of these two rates. Let’s get started.

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What is Flat Interest Rate in a Personal Loan?

The flat interest rate in a personal loan implies that the interest will be charged on the principal loan amount throughout the loan tenure, irrespective of how much principal has been repaid from time to time.

What is Reducing Balance Interest Rate?

The reducing balance interest rate means the interest will be charged on the reduced balance of the loan amount. Now the interest could be charged on the reduced balance on a monthly or yearly basis. There are daily, monthly and annual reducing balances that lenders offer on a personal loan.

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As the name suggests, the daily reducing balance means the lender will charge interest on the reduced outstanding balance every day. Since the outstanding balance reduces with each EMI payment that you make at the end of every month, the daily reducing system is not getting used much.

In a monthly reducing balance system, the personal loan interest rate will be charged on the outstanding principal balance left after each EMI payment.

The annual reducing balance system means the interest rate will apply to the outstanding principal amount at the end of each year.

Lenders, these days, are not using the annual reducing balance method. So, there’s only monthly reducing balance available now.

Which Saves You on a Personal Loan?

Let’s consider an example below and check which of the two – flat and monthly reducing balance – saves you more.

Example – Ravi and Ganesh apply for a personal loan of 5 lakh at an interest rate of 16% per annum. While Ravi gets the loan at a flat rate, Ganesh receives on an annual reducing balance basis. Let’s check out the effect in the table below.

Loan AspectsRaviGanesh
Loan AmountINR 5,00,000INR 5,00,000
EMIINR 15,000INR 12,159
Interest OutgoINR 4,00,000INR 2,29,542
Total OutgoINR 9,00,000INR 7,29,542

While calculating the repayment for Ravi, a flat 16% interest rate is applied to the principal loan amount of INR 5,00,000. So, the annual interest payment comes as INR 80,000 (16% of INR 5,00,000). Since the loan is for 5 years, the total interest payment will be INR 4,00,000 (80,000×5). If we add the principal amount of INR 5 lakh to this total interest, the total outgo will be INR 9 lakh. The EMI will be obtained by dividing the total outgo by the number of months. Here, INR 9 lakh will be divided by 60 months. This will give a sum of INR 15,000. Whereas, repayment estimates for Ganesh are calculated via the personal loan EMI calculator of Wishfin.

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Can You Convert Your Flat Interest Rate into Reducing Balance?

The benefit of having a monthly reducing balance is best demonstrated through the example shown above. So, if you have taken a personal loan at a flat interest rate and want to convert it into a reducing balance, you should first contact your lender and request it to do the same. If it agrees, it can reduce some interest obligations for you. If it does not, you should look to transfer the outstanding loan balance to another lender at a lower rate of interest and on a reducing balance basis. The new lender will go through your loan statement to check how much outstanding balance you have, the principal and interest repayment made so far, your credit score, etc. Since it is an unsecured loan, the lender would want a credit score of 700 and above to approve the personal loan balance transfer deal. Plus, it will keep an eye on the overall repayment track before allowing you this facility.

Can a Lender Impose a Flat Personal Loan Interest Rate for Borrowers Having a Poor Credit Score?

Normally, lenders don’t give personal loans to borrowers having a poor credit score. They ask such borrowers to apply for a loan against any of the following –

  • Fixed Deposits
  • Mutual Funds
  • Shares
  • Bonds
  • Property
  • Gold

But some lenders, mostly non-banking finance companies (NBFCs), can offer a hardcore personal loan to such borrowers on a flat basis. The personal loan interest rate can be much higher in that case.

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  • Personal Loan Interest Rates September 2020
    Fullerton India14.00% - 33.00%
    HDFC Bank10.75% - 21.45%
    ICICI Bank10.75% - 18.49%
    IndusInd Bank11.25%
    Kotak Bank10.99% - 20.99%
    RBL17.50% - 24.00%
    Standard Chartered Bank11.00% - 15.00%
    Tata Capital10.99% - 18.00%