The Illusion of Cheap Interest Rates
When borrowing, you may come across dealers offering a "Flat Rate" of 7% p.a., while banks quote a "Reducing Balance Rate" of 11% p.a. On first glance, the flat rate seems cheaper. However, this is a marketing illusion. A flat interest rate is almost always more expensive than a reducing balance rate, as it calculates interest on the full initial loan amount throughout the entire tenure, ignoring monthly principal repayments.
Understanding these math dynamics helps you make smarter loan comparisons. If you plan to borrow, read about personal loans vs credit card loans to see which is a better option.
The Mathematical Difference: Flat vs. Reducing
Let's compare a Rs. 5,000,000 loan at a 10% rate for 5 years using both methods:
- Flat Rate Method: Interest is calculated on the initial principal every year. Even in year 5, when you have repaid most of the loan, you still pay interest on the full Rs. 5,000,000. The effective rate is around 18% p.a.
- Reducing Balance Method: Interest is calculated monthly only on the remaining outstanding principal. As you pay your EMIs, the outstanding principal drops, reducing your interest burden. This is the industry-standard method used for home and car loans.