How personal loan interest is calculated: reducing balance vs flat rate

Reducing balance: interest on what you still owe

Most bank loans use the reducing-balance method. Each month, interest is charged only on the principal that is still outstanding. Your EMI stays the same, but early instalments are mostly interest, and as the principal falls, more of each EMI goes towards repaying it.

The standard EMI formula for this method is EMI = P × r × (1 + r)^n ÷ ((1 + r)^n − 1), where P is the loan amount, r is the monthly interest rate (the annual rate divided by 12) and n is the number of monthly instalments.

Flat rate: interest on the full amount, always

With a flat rate, interest is calculated on the original loan amount for the whole tenure, even though you are repaying the principal every month. You pay interest as if you still owed the full sum until the very last instalment.

Flat rates are used by some lenders for small, short loans and in some consumer finance offers. Because they ignore the fact that your balance shrinks, they look lower than they are.

A worked example

Take a loan of 5,00,000 rupees for 3 years (36 months).

At 12 percent on a reducing balance, the EMI comes to about 16,607 rupees, and the total interest you pay is about 97,900 rupees.

At a flat 12 percent, the interest is 5,00,000 × 12% × 3 = 1,80,000 rupees. Added to the principal and divided across 36 months, the EMI is about 18,889 rupees. Compared with the reducing-balance loan, you pay roughly 82,000 rupees more in interest for the same "12 percent".

Put another way, a flat 12 percent on this loan works out to an effective annual rate of roughly 21 percent. That is the number you should compare against other offers.

How to compare offers fairly

• Ask whether the quoted rate is flat or reducing balance. If a lender will not say, treat it as flat.
• Compare the total amount you will repay over the full tenure, not just the EMI.
• Include the processing fee, which is usually a percentage of the loan and deducted upfront, so you receive less than you borrowed.
• Check prepayment and foreclosure charges. Some lenders charge a penalty if you repay early, which can make a cheaper-looking loan more expensive.
• Ask for the APR or the effective interest rate, which folds fees and the calculation method into a single comparable figure.

Use a calculator before you sign

The EMI calculator on Truely Money uses the reducing-balance formula and shows the full amortisation schedule, so you can see how much of each instalment is interest and how the balance falls. Try a few tenures: a longer tenure lowers the EMI but raises the total interest you pay.

This is general information, not personal financial advice. Always read the lender's sanction letter and key fact statement before accepting a loan.