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What Is Reducing Interest Rate?
Posted on Wednesday, December 18th, 2024 | By IndusInd Bank
Interest rates are a key factor in determining the cost of borrowing. But not all interest rates are calculated the same way. While some loans come with a flat interest rate, others use a method called the reducing interest rate—often considered more borrower-friendly in the long run. In this blog, we’ll break down how reducing interest rates work, their advantages, and why they might be a better option for your personal loan.
What Is Reducing Interest Rate?
A reducing interest rate, also known as a diminishing or declining balance rate, is a method where the interest is charged only on the outstanding loan amount—not the full principal. This means as you continue to repay the loan, your interest outgo reduces over time because the remaining loan balance keeps decreasing.
This type of rate offers better value for borrowers, especially for longer tenures, since the interest payable declines with each EMI.
Understanding Reducing Interest Rate
A reducing interest rate, meaning a diminishing or declining balance interest rate, is a method of calculating interest where the interest is charged on the outstanding loan balance. As you repay the principal amount, the interest is recalculated on the reduced principal amount, leading to a gradual decrease in the total interest paid over the loan tenure.
Here’s a simplified illustration:
- Imagine you take a loan of ₹ 1,00,000 with a reducing interest rate of 10% per annum.
- In the first month, the interest is calculated on the entire loan amount (₹ 1,00,000).
- After your first repayment, the principal reduces.
- In the second month, the interest is calculated on the new, reduced principal amount, and this process continues throughout the loan tenure.
This method is in stark contrast with a flat interest rate, where the interest is calculated on the original principal amount for the entire duration of the loan, resulting in higher interest payments.
Reducing Interest Rate Formula
Here’s the formula used to calculate the EMI under a reducing interest rate:
EMI = [P × R × (1+R)^N] / [(1+R)^N – 1]
Where:
- P = Principal loan amount
- R = Monthly interest rate (annual rate divided by 12 × 100)
- N = Loan tenure in months
This formula factors in both the principal and the declining interest, offering a realistic picture of monthly outgo.
Benefits of a Reducing Interest Rate
A reducing interest rate offers several advantages, especially for those looking to minimize total interest paid over the loan duration:
Lower Interest Payments
Since the interest is calculated on the diminishing principal, the total interest paid over the loan tenure is significantly lower compared to a flat interest rate loan.
Transparency
Borrowers can easily see how their repayments are reducing the principal and the interest component using a loan repayment schedule. Thus, offering clarity and peace of mind.
Cost-Effective
Particularly for long-term loans, reducing interest rates prove to be more economical than flat interest rates.
Choosing the Right Interest Rate: Flat vs Reducing Interest Rate
When opting for a personal loan, compare the total cost of borrowing under different interest rate methods. Here’s a quick comparison:
- Flat Interest Rate: The interest is calculated on the entire principal amount throughout the loan tenure, offering predictability in EMIs.
- Reducing Interest Rate: The interest is calculated on the outstanding principal, resulting in lower interest payments over time. This method can be more economical, especially for long-term loans.
Also Read: Understanding Personal Loan Interest Rates
Wrapping Up: Why Reducing Interest Rate Is the Smarter Choice
Understanding the nuances of interest rates can significantly impact your borrowing decisions. A reducing interest rate, with its method of calculating interest on the outstanding principal, can offer substantial savings over the loan tenure. Along with the interest calculation methodology, your credit history, your banking partner and the like can impact your personal loan experience.
