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Flat Interest vs Reducing Interest Rate - Which offers Lower EMI?

By PolicyBazaar

Personal Loan up to 8 times your Salary

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Financial institutions and banks offer multiple loans like personal loans, car loans, home loans, gold loans, etc. The process of application and required documents might vary based on the category of loan or from bank to bank. Having said that in order to land on the perfect deal, one should be aware of some important financial jargon that is vital in the long run to ensure the right decision. One such term is the personal loan interest rate in UAE! 

Let’s dive into depth on how banks and financial institutions determine the rate of interest applicable to your loan. In a scenario like this where bank representatives usually do not inform you about the exact rate of interest, you must have a clear understanding of the entire process and various factors that play a key role in the overall process. 

 What if you had to choose between personal loan interest rate in UAE of 12% or 24%. Naturally, most of us would go for the option that has a lower rate as it appears cheaper and will eventually result in savings.  

But wait there’s more… 

Personal loan interest rate in UAE that appears cheaper in comparison to the other may not be cheaper in real-time. So, the answer to this paradox is that banks mainly offer two types of interest rates i.e. flat interest rate and reducing or diminishing interest rate. Let us understand both the types of personal loan interest rate in UAE and how are they different from each other in real-time scenarios.

Flat Interest Rate

As the name indicates flat rates of interest are calculated over the total amount of loan through its entire tenure excluding the reduction in the principal amount due to the monthly EMI’s. By convention, debtors are supposed to make monthly payments in the form of EMI to settle the loan over a given period of time known as the repayment tenor. Technically, the rate of interest is calculated over the principal amount of the loan that was disbursed by the bank. When one makes the repayment in the form of EMIs the principal amount is gradually reduced and henceforth the interest rate should go down.

That’s not the case with a flat rate of interest, as it is calculated on the total amount of loan, the effective rate is usually higher than the nominal quote in the beginning. Flat rates of interest for loans are less popular amongst borrowers because with the loan gradually being paid off, there is no reduction in the rate of interest. 

The interest rate that is to be paid by the debtor per installment 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.

Reducing Interest Rate

Reducing rate of interest means that the calculation of interest is done every month over the outstanding principal amount of the loan. In this method, EMI’s only include the interest that is payable over the outstanding amount and not the entire amount. Every time the debtor pays an EMI, the outstanding amount reduces that eventually reduces the interest. Reducing rates of interest are usually applicable in the case of property loans, mortgage, housing loans, credit cards, etc. The interest rate that is quoted for such loans is similar to interest rates that are used in the case of fixed deposits. 

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. 

This type of interest rate is usually applicable in the case of mortgage loans, property loans, and overdrafts. This interest rate is considered as an effective rate and the same calculation method is used to determine interest applicable over FDs and savings bank accounts. The reducing personal loan interest rate in UAE is more popular in comparison to the flat rate as it helps to save a bit more in terms of the payable rate.

Differences between Flat Rate & Reducing Rate of Interest

  • In a flat rate of interest, the interest is calculated over the entire loan amount and not the outstanding amount, whereas in the case of reducing interest rates the interest is calculated only over the outstanding amount of the loan every month.
  • The flat personal loan interest rate in UAE is usually lower than the reducing rate.
  • The flat rate of interest is easy to calculate due to limited and simple calculations, whereas reducing rates of interest are a bit complex to calculate because of the lengthy calculations.

In order to have a clear and firm understanding of both the types of interest let us consider an exemplary situation- 

Suppose you have opted for personal loan in the UAE for the amount AED 1,00,000. Now the rate of interest applicable on the loan is flat rate 10% and the repayment tenor is 4 years.

In the second scenario, you have opted for the same loan AED 1,00,000 with a reducing rate of interest 10%  with a repayment tenor of 4 years. 

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 18260 Less

Bottom-line

Whenever you look forward to getting a personal loan it is very important to have proper knowledge about the personal loan interest rate in UAE that is applicable over the loan. In multiple cases, there is a very high possibility that a flat personal interest rate in UAE at a lower interest rate turns out to be expensive than a loan at a reduced rate of a higher percentage.

So make sure you do detailed research and then go ahead with any financial decision.