When choosing a loan, whether it is a home loan, personal loan, vehicle loan, educational loan or any other, you will be presented with two types of Equated Monthly Instalments (EMI). These are the fixed or flat interest rate EMI and the reducing interest rate EMI. It helps to understand what these are, the differences between the two, and the pros and cons of each before you choose so that you will make the best decision for your specific requirements.
Fixed Interest Rate EMI
A fixed or flat rate EMI is one where the lending rate, or interest, remains unchanged throughout the tenure of your loan. The interest for the entire loan tenure will be calculated at the start of the tenure itself.
Formula for Calculating Fixed Interest Rate EMI
The formula for calculating the fixed interest rate EMI is as given below:
Interest to be paid on each instalment = (Loan principal amount x total tenure of the loan x interest rate per annum)/sum total of instalments
Reducing Balance EMI
Reducing balance EMI is also called reducing balance interest rate or diminishing interest rate. Here the interest amount accrued will vary depending on the principal loan amount that is outstanding based on the effective lending interest rates.
Formula for Calculating Reducing Balance Interest Rate EMI
The formula for calculating the reducing balance interest rate EMI is as given below:
Interest to be paid on each instalment = The remaining loan amount x the interest rate that is applicable for each instalment
Difference between Fixed Interest Loan and Reducing Balance Loan
The differences between a fixed interest rate EMI and reducing balance EMI based on various parameters are as given below:
- Interest rate: Loans with fixed rate of interest generally have lower rates of interest than loans with reducing balance.
- Interest rate calculation: The interest rate calculation for a fixed interest loan is simpler than that of a reducing balance loan.
- Amount on which interest is calculated: For a fixed interest rate loan, the calculation will be based on the total amount sanctioned whereas for a reducing balance loan it will be based on the principal amount that is outstanding.
- Loan tenure: The loan tenure of a fixed interest loan will usually be longer than that of a reducing balance loan.
Pros and Cons of Fixed vs Reducing Balance Loan EMIs
Before deciding which is the best type of EMI to choose for your loan, it helps to understand the pros and cons of each of the two types. Here are some pointers based on certain parameters:
Advantages of fixed interest rate loans: The monthly amount to be paid does not change with time, which can help to manage and plan your monthly budget ahead of time. The interest rate on such loans is lower which is beneficial for those with lower loan eligibility. The repayment tenure is longer which can help with more flexibility in repayment.
Disadvantages of fixed interest rate loans: You will be paying the same interest rate throughout the tenure of the loan even if lending rates are reduced by the bank. The EMI amount may also be higher.
Advantages of reducing balance Interest rate: The interest paid on a reducing balance loan reduces over time since it is calculated on the principal amount that is outstanding, hence theamount of interest paid will gradually become lesser than that of a fixed interest loan.
Disadvantages of reducing balance interest rate: The interest rate calculation is more complicated.
Calculation of Fixed vs Reducing Balance EMI
Let’s understand the fixed/flat interest calculation method and the reducing balance methodwith an example using the following parameters:
- Loan worth is Rs. 25,00,000
- Loan Tenure is 1 year
- Rate on interest is 12%
Fixed or Simple Interest Calculation Method:
As per this method the interest is calculated on the principal amount. In this case it is Rs.25,00,000. The method is used to calculate the interest for the entire tenure of loan. In this case it will be Rs.3,00,000. The interest arrived at will be added to the principal (which will be Rs.28,00,000). This will further be divided into 12 equal parts to arrive at your monthly EMI. In this case it will be Rs.2,33,333. The total interest to be paid, in this case is Rs.3,00,000.
Reducing Balance Method:
Considering the same value for loan amount, interest rate and loan tenure, we will calculate the EMI amount arrived at, according to the reducing balance method. The EMI, post calculation, comes to Rs.2,22,121. As per this mode of interest calculation, whatever you pay towards your monthly EMI gets reduced in that principal part. Apart from this, interest will be calculated on the rest of the amount and you shall be charged for that month. So it is understandable that the principal will not be constant in this method. It decreases gradually, on a monthly basis, and at the end of 12th month the principal stands at an amount of zero. Please note that during the initial stages of the loan, the major part goes in interest and minor part goes towards principal.
Keeping the basic data same and calculating the interest with two different methods, it can be seen that the simple/fixed interest calculation method demanded a total of Rs.1,34,537 high interest than reducing balance method. This explains why it is important to look at the interest calculation method, and not just the interest rate offered. It is true that such type of simple or fixed interest calculation method loans provide you a lower interest rate than that of reducing balance method loans. Therefore, make sure that you ask the loan provider the detailed difference in interest payment, and only then decide to avail the loan. A good choice of loan provider will not only fulfil your financial needs, but also be easy on your pocket.
- Which is better – fixed or reducing balance EMI?
- What decides the interest rate in a reducing balance EMI?
- How to calculate EMI for the entire loan tenure before taking the loan?
Making the choice of a fixed or reducing balance EMI should be done keeping in mind your financial requirements and repayment capacity. A fixed EMI will usually have lower rates of interest and longer repayment tenure but a higher EMI with interest that is fixed throughout the loan tenure and calculated on the entire loan amount. A reducing balance EMI may have lower EMIs and shorter repayment tenure because the interest rate will vary and is calculated on the principal amount outstanding, which will be reducing over time.
The interest rate in a reducing balance EMI depends on the lending rates of the bank which in turn will be influenced by repo rates set by the Reserve Bank of India (RBI). This will in turn depend on various economic scenarios, both domestic and global.
It helps to understand what your EMIs will be for your entire loan tenure before taking the loan. While this can be done with a manual calculation, it is best to do it with one of the free online EMI calculators that will give you a detailed amortisation schedule for your entire loan tenure based on your loan amount, loan tenure, and interest rate.