Flat Interest vs Reducing Interest Rate

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An Overview of Flat Vs Reducing Rate of Interest

The following table draws a comparison between flat vs reducing rate of interest –

Basis of Difference

Flat Rate of Interest

Reducing Rate of Interest

Interest Calculation

Computed on the original principal amount

Computed on the overall remaining principal amount 

Degree of Complexity in Calculation

The calculation employs an easy-to-understand formula

The interest rate calculation is relatively complicated as the rate is calculated every month on the remaining principal amount throughout the repayment tenure

Interest Liability

The interest rate charged is constant and the liability is higher than the reducing rate

The interest payable reduces with time and thus reduces the overall interest liability

There are three key elements of a personal loan – principal amount, loan repayment tenure, and interest rate payable. The interest rate indicates the charges that you would need to pay when securing a personal loan. Most lending institutions in the UAE calculate the interest payable on personal loans in two ways – flat rate of interest for a personal loan and reducing rate of interest for a personal loan. Both techniques give a different interest amount payable.

Thus, before applying for a personal loan, it is crucial to understand the difference between flat vs reducing rates of interest. By knowing the difference between the two, you can make an informed choice of taking a loan either on a flat rate or a reduced rate of interest for a personal loan. 

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What is a Flat Rate of Interest for a Personal Loan?

A flat rate of interest for a personal loan is a type of interest rate that remains unchanged throughout the loan repayment tenure. Since the interest rate to be paid is fixed, your instalments remain consistent throughout the term. 

This rate of interest is generally higher than the reducing rate of interest for personal loans and is computed on the total principal loan amount.

The interest rate that is to be paid by the debtor per instalment can be calculated by the formula- (PTR)/I

where P=Principal or original loan amount

T= Number of years or repayment tenor

R= Rate of interest per annum

I= Total number of installments  

In order to understand the concept and the usage of this formula let us consider an exemplary situation,

Suppose you have opted for a personal loan of AED 100000 with an interest rate (flat) of 10% for a repayment tenor of 5 years.

Annual you will end up paying,

EMI for the loan = Principal amount/No. of years i.e. 100000/5 = AED 20000

Payable Interest = 10% of AED 100000 = AED 10000

Total = 20000+10000= AED 30000 P.A / AED 2500 per month 

Over the entire duration, the debtor would actually be paying i.e. (2500*12*5) = AED 150000. When you convert the monthly into personal loan interest rate in UAE it equals 17.27% flat P.A.

This rate is usually applicable in case of personal and vehicle loans as one needs to pay interest on the entire loan amount during the course of the entire repayment tenor. A major drawback in the case of flat personal loan interest rate in UAE is that they are approximately 1.6 -1.8 % higher when converted to the interest rate in real-time.

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Benefits of Flat Rate of Interest for Personal Loan in UAE

Here are the major benefits of a flat rate of interest for a personal loan –

  • Easy Computation – When you secure a personal loan on a flat interest rate, you can easily predetermine the monthly instalment amount as the interest would be calculated on a fixed amount i.e., the total principal amount.
  • Easy to Understand – The calculations involved in estimating the flat rate of interest for a personal loan are relatively easy to understand and transparent.
  • Fixed Monthly Instalments – As the payable interest payable remains constant and computed on the principal amount, the instalments remain the same. Constant instalments can further help you fix your monthly budget.

What is the Reducing Rate of Interest for a Personal Loan?

With a reduced rate of interest for a personal loan, the interest is calculated every month on the remaining loan amount instead of the total principal amount. The interest amount, thus, varies as per the outstanding principal amount. As the outstanding amount reduces as you repay the loan, the applicable interest also diminishes over time.

To understand with an example, let’s assume that Ahmed has taken a personal loan of AED 400,000 at a reducing rate of 6%, and the interest to be paid at the time of the first instalment would be AED 24,000. After this, the outstanding amount will be AED 324,000. However, the payable interest this time will be AED 19,440. With each instalment, the applicable interest will reduce.

The payable rate of interest per installment can be calculated using the simple formula- R-O

Where, R= Rate of interest

O= Outstanding or remaining amount of loan 

To understand the concept, let us consider another exemplary situation-

Suppose you have opted for a personal loan equivalent to the amount of AED 100000 with an interest rate (reducing) of 10% over a repayment tenor of 5 years.

Since in the case of reducing interest rate the amount is calculated by reducing the paid EMI from the principal amount in the first year of the repayment tenor one will end up paying AED 10000 as an interest followed by AED 8000 in the second year, AED 6000 in the third year, AED 4000 in the fourth year and AED 2000 in the last year. Contrary, to the case of a flat rate of interest the debtor will only pay AED 130000 instead of AED 150000. 

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Benefits of Reducing Rate of Interest for Personal Loan

Given below are the major advantages of reducing rate of interest for a personal loan –

  • Diminishing Interest Amount – The interest amount reduces as the outstanding loan amount reduces over time.
  • Cost of Loan – When you use the reducing interest method to compute the cost of a loan, the amount generally comes out to be lower than the amount calculated at a flat rate of interest.

The table below will help you to understand the difference between flat rate of interest and reducing rate of interest in case of different types of loans.

Personal Loan amount

Interest Type

Interest Rate

Repayment Tenor

Total Repayment Value

Difference

100000

Flat

10%

4 Years

AED 1,40,000

 AED 18260 More

100000

Reducing

10%

4 Years

AED 1,21,740

AED 1

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In a Nutshell

Flat rate of interest for a personal loan is suitable for microfinancing like taking a loan to get a new electronic device or furniture. However, the reducing rate of interest is mostly considered a better alternative as you wouldn’t be paying the same amount every time without taking the principal amount into account. 

However, given the complicated calculation, several individuals end up opting for loans computed using the flat rate method. This can be tackled to a great extent by using an advanced personal loan calculator from any of the top banks or institutions, as they display the results for both types of interest rates without requiring any major effort on your part.

Frequently Asked Questions

Which of the two methods offers a lower monthly instalment payable?

When you compute your monthly instalment using the reducing rate of interest for a personal loan, you can get a lower EMI as the instalments are calculated based on the outstanding principal amount.

What is an effective interest rate?

Effective interest rate indicates the usage rate of interest that you, as a borrower, pay on a loan. Also known as the market rate of interest and yield to maturity, this interest rate can differ from the interest rate payable in the documents.

Which interest rate payable is preferable?

The method of calculating the interest rate depends on the flat rate and reducing rate the bank offers. If the flat rate is lower than the reducing rate of interest for a personal loan, the former is a better option. However, if the flat rate offered is high, it is recommended to opt for the reducing interest rate method.

How can you compute the EMI for the entire loan tenure before securing the loan?

To calculate the monthly instalment to be paid, you can use online EMI calculator tools which can provide you with an elaborate amortisation schedule for your entire loan duration. The calculation is done based on the principal amount, interest rate, and loan duration.

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