What is the Difference Between Reducing & Fixed Interest Rate?

Interest on loans is the cost for a borrower. Interest rate is known to be the percentage of the loan, which is calculated on an annual basis in the form of Annual Percentage Rate (APR). There are different ways in which interest rates are calculated, even for personal loans.In this article, we highlight the pros and cons of fixed vs reducing interest rates and which is better for personal loans.

While it is established that personal loan interest is calculated either through fixed interest rates or reducing interest rates. The difference between fixed vs reducing interest ratesdepends on whether interest is to be applied to the initial principal or balance outstanding principal.

Fixed Interest Rate:

In this method, the personal loan interest rate is calculated on the initial principal amount regardless of the principal repaid. From fixed vs reducing rates, opting for a fixed interest rate results in a higher EMI. Here is an example of the fixed interest rate.For instance, if X opts for a loan of ₹1,00,000 at an interest rate of 10 per cent for 3 years, the interest component for each comes down to ₹10,000 making the total principal amount and interest to be ₹1,30,000. This means if we pay the EMI for 36 months, the interest component comes down to ₹3612 per year.

Reducing Interest Rate:

From fixed vs reducing rates, reducing rate for a personal loan calculates interest on the principal amount outstanding at the end of a specific period. As and when you pay the EMI’s, a certain portion of your principal is reduced, and the balance goes for your interest. For the next month, the interest cost will vary since it will be calculated on the new principal outstanding.For instance, if X opts for a loan of ₹5,00,000 with an interest rate of 15 per cent for 5 years, the EMI will come down to ₹11,895 resulting in a total EMI amount to be of ₹1,42,740 of which  72,596 goes for interest and the balance ₹70,144 goes towards interest. However, for the next amount, 15 per cent of interest will be calculated on the principal balance outstanding, which is ₹4,37,404.As a comparison offixed vs reducing rates, it is evident that the EMIs for the flat interest rate is higher when compared to reducing the interest rate. This is because the interest for the latter is calculated on the total principal amount. The best way to find out which interest rate type is ideal for you is by using a personal loan calculator and see which offers a lower interest rate.

The information contained herein is generic in nature and is meant for educational purposes only. Nothing here is to be construed as an investment or financial or taxation advice nor to be considered as an invitation or solicitation or advertisement for any financial product. Readers are advised to exercise discretion and should seek independent professional advice prior to making any investment decision in relation to any financial product. Aditya Birla Capital Group is not liable for any decision arising out of the use of this information.