Flat Rate Method v/s Reducing Balance Method of calculating interest – Explained

Flat Rate Method v/s Reducing Balance Method of calculating interest – Explained

What is Interest?

Interest is the amount you pay to borrow money from Financial institutions or Lenders. Therefore the borrower will pay the principal amount of the loan plus an extra sum, referred to as interest.


Why is the Interest charged?

Lenders earn profits and therefore the interest they charge is the amount you pay for borrowing the money.


What's an Equated Monthly Installment (EMI)?

  • An EMI could be a fixed payment made by a borrower to a lender on a specified date of every month.
  • EMIs are often calculated in two ways: The Flat Rate Method (FRM) or the Reducing Balance Method (RBM).
  • The EMI in RBM is more favorable for borrowers than the FRM because it leads to lower interest payments overall.
  • EMIs allow borrowers the peace of mind of knowing exactly what quantity of money they'll pay monthly toward their loan.

Types of EMI :

  1. Flat Rate Method - A Flat rate of interest means the interest paid is fixed. In this method, the interest is calculated on the initial loan amount throughout its tenure, thus interest remains constant and doesn't reduce because the principal amount decreases along with your monthly EMI.
  2. Reducing Balance Method: In this, the interest to be paid is revised each month on the outstanding loan amount. In this method, the EMI includes interest payable for the outstanding loan additionally to the principal repayment. Now, since the principal amount reduces with every EMI payment, the interest payable thereon also reduces.

Examples of FRM and RBM:-

Details FRM RBM
Principal Amount 1,00,000 1,00,000
Rate of interest 15% 15%
Tenure 6 months 6 months
Interest amount for 6 months 7,500 4,402
Effective interest through respective method 25.27% 15%
Savings through RBM (7,500 - 4402) - Rs 3,078.

The biggest difference between the two is that in FRM the rate is calculated on the initial principal amount of the loan. On the other hand in the RBM, the rate of interest is calculated only on the outstanding loan amount on a monthly basis.

Conclusion:

At Monethics, our customers are at the centre while defining any policy. Hence, transparency and other customer friendly policies are what we always offer to our customers.

One small example of this transparency and customer-centric policy is that Monethics charges interest through the Reducing Balance Method (Saving of 10.3%p.a.) and not at the Flat Rate Method and thereby helping its customers to save a lot of money as shown in the above example.

Truly - Paisa bhi, Sukoon bhi