Flat rate vs floating rate is relevant when you are confused about why Bank quoting higher EMI is telling you lower interest rate (Flat rate) whereas one with lower EMI is quoting a higher rate (Floating rate).
This is because the interest calculation was done in different ways i.e. Flat rate vs floating rate.
As the name suggests, the Interest that is charged every month is as per the principal left on loan amount and not the full loan amount.
Thus when you take a loan and start to pay the EMIs, the Loan Amount (Principal) is reduced every month and hence the interest amount reduces month on month.
Below an example for Rs 1 Lac loan for 12 months at a 10% interest rate.
Total Interest to be paid with floating interest rate in above case is Rs 5,499.
Here, as the name suggests, the interest in this method remains the same and does not reduce month over month.
Hence Simple Interest is calculated on the total Loan disbursed and then divided over the tenure in months to calculate the EMI.
Let us now consider the above example and see how much the interest cost would be for 10% flat rate for Rs 1 Lac for a period of 1 year.
Simple Interest for 1 year on Rs 1 Lac at 10% would be Rs 10,000.
We can observe from the above examples
- With the Reducing Balance Method, the total interest amount to be paid would be Rs 5,499.
- Whereas with Fixed Interest rate, the total interest amount to be paid would be 10% of the principal amount i.e. 10% of Rs 1 Lac and that is Rs 10,000.
Hence one can see that for the same interest rate quoted, one has to pay a lot more interest for the same loan amount with the flat rate.
Bank may charge floating interest rates, but the agent or salesperson may tell you a lower rate which is nothing but a flat rate. So always ask for the reducing balance rates at which most banks/NBFCs do the lending.
This would help you to compare the loans judiciously and make a better financial decision.