How does the Type of Interest Rate Affect Your Personal Loan EMI?

How does the Type of Interest Rate Affect Your Personal Loan EMI?

When you are contemplating availing a Personal Loan, you should make a final decision only after comparing various key aspects of different offers. One of the most important factors that can affect your final decision is the interest rate charged by the bank. Interest rates applicable against a Personal Loan are slightly higher due to being unsecured in nature. There are various online calculator tools available which you can use to calculate the total interest cost that you will have to bear.

## Rate of Interest

Personal Loans are available from numerous financial institutions in present times. As all the lenders charge a different Personal Loan Interest Rate, making a decision requires a careful comparison between the available offers. Many lenders lack transparency when it comes to interest rates. While advertising Personal Loans, they will always put an asterisk against the offered interest rate, signifying that there are certain terms and conditions applicable.

Other than the overall interest rate being charged by the lender, there is one more aspect pertaining to Personal Loan interest rates that you need to take care of, i.e., the type of interest rate. Many lenders give you the option of choosing between the flat interest rate and reducing the interest rate. So, which of these options is more suitable for you, let’s analyze.

## Flat Interest Rate

As the name suggests, the rate of interest calculated remains the same throughout the repayment tenor. Herein, the interest component and the principal component in the EMI will remain the same throughout the repayment period. The interest calculation is done at the commencement of the repayment tenor on the principal amount, and it remains unchanged throughout. The formula used for calculation is:

Interest payable per installment = Original Principal (P) x Repayment Period (T) x Rate of Interest (R) / Number of installments

## Reducing Rate of Interest

This is also known as reducing balance interest, wherein the interest component of the EMI is calculated every month on the outstanding balance. As the principal outstanding reduces every month with the repayment, the interest is calculated on the remaining principal amount. Consequently, the interest component in the EMI also reduces proportionately. As a result, towards the end of the repayment period, the EMI majorly comprises of the principal component. The formula used for calculating the interest per instalment under this system is:

Interest payable per installment = Outstanding loan amount x Rate of Interest

## Comparative Analysis of Flat interest Rate vs. Reducing Interest Rate

Here is a comparative analysis of these two interest calculation systems that will help you understand them in a better way.

 Parameter Flat Interest Rate Reducing Interest Rate Interest calculation The calculation is based on the original principal amount The calculation is based on the outstanding principal amount Cost You end up paying higher interest cost You save on your interest cost payments Ease of calculation Extremely easy to calculate Requires basic financial knowledge Usability Very rarely used Most commonly used
• Interest calculation: As explained above, the interest calculation under the flat-rate system is done on the original principal amount and thus remains the same throughout the loan tenor. The interest under the reducing rate system is done on the outstanding balance at the beginning of the month and thus keeps on varying.
• Quantum: While flat interest rates might seem to be more suitable for a borrower but in effect, the borrower ends up paying approximately 60-90% more interest under this system, as compared to reducing rate structure.
• Ease of calculation: Under the flat-rate system, calculations are easier for the borrowers as the formula is pretty simple. While the calculation of interest under reducing rate structure is somewhat complex and can be best done using online Personal Loan calculators.
• Usability: Due to higher interest costs that borrowers have to incur,the flat-rate structure is not preferred by the borrowers. In comparison, reducing rate structure is widely used as it helps reduce the interest cost.

## Flat Interest Rate vs. Reducing Interest Rate

As interest payments are a big drain on your finances, you must opt for such an interest rate structure that reduces your interest payments and therefore help you save a significant sum of money. Now comes the big question, i.e., which of these two interest rates should you opt for. Let’s understand with an illustration.

Suppose you avail of an HDFC Personal Loan of Rs. 2,00,000 and opt for a repayment period of 5 years. Now, let’s assume that the HDFC Personal Loan Interest Rate is based on a flat rate structure and is calculated at 11% per annum. So, your EMI comes out to Rs. 5,167 out of which Rs. 1,833 per month is the interest cost and Rs. 3,334 is the principal. This EMI structure will remain the same throughout the loan period. Thus, by the time the entire loan is repaid, you will have incurred the interest cost of Rs. 1,10,000, resulting in a total repayment of Rs. 3,10,000.

Now, let’s assume that instead of HDFC Personal Loan, you avail an ICICI Personal Loan of Rs 2,00,000 with the same repayment period of 5 years. We further assume that the ICICI Personal Loan Interest Rate is based on a reducing interest rate structure and is also calculated at 11% per annum. As per the formula, your EMI herein comes out to be Rs. 4,348. The principal and interest component will vary with each EMI as they are calculated on the outstanding principal only, By the time, the loan repayment tenure ends, you will have incurred an interest cost of Rs. 60,880, and the total repayment would be Rs. 2,80,880.

On comparison, it is evident that you not only will you have to pay a lower EMI under the reducing balance structure but will save Rs. 49,120 over the repayment period.

Also Read: Excel Loan Calculator – Step by Step Process of EMI Calculation

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