When it comes to securing a business loan, one of the most pivotal factors to evaluate is the interest rate. For entrepreneurs, business loan interest rates are often the linchpin influencing their choice of lender and the ultimate decision to proceed with a loan application. These interest rates play a pivotal role in shaping the equated monthly installments (EMIs), which become a mandatory financial commitment for your enterprise. Therefore, it is essential for business owners to gain a deep understanding of the applicable interest rates, their calculation methodologies, and the significant distinctions between flat interest rates and reducing rate of interest before embarking on the loan application journey.
For Micro, Small, and Medium-sized Enterprises (MSMEs), the decision between opting for a flat or reducing rate of interest is particularly critical due to their inherently delicate financial ecosystems. MSMEs often operate on slender profit margins and have limited financial resources. Therefore, the choice of interest rate structure significantly impacts their cash flow, sustainability, and ability to seize growth opportunities. Opting for the right interest rate structure can mean the difference between manageable EMIs that support steady operations and excessive financial strain that could hinder their growth prospects. Let’s explore how flat vs. reducing rate of interest works out for businesses.
What is a Flat Rate of Interest?
Flat interest rates are a specific type of interest calculation that maintains a constant rate throughout the entire loan tenure. This means that the interest rate remains unchanged, even if the principal loan amount gradually diminishes over time. Typically, flat interest rates structures find application in loans such as car loans, mortgages, and other financial arrangements where borrowers commit to repaying the loan within a stipulated time frame.
Consider this scenario to understand how flat interest rates work: An MSME entrepreneur secures a loan of Rs. 100,000 with a flat interest rate of 10%. In this case, the annual interest amounts to Rs. 10,000. Consequently, the entrepreneur must make monthly payments comprising both principal and interest components. These monthly payments will start with relatively higher amounts in the initial years of the loan when the principal balance remains substantial. As time progresses and the principal amount decreases, the monthly payments gradually decrease as well.
While flat interest rates are relatively easier to comprehend and calculate, they tend to be more expensive compared to the reducing rate of interest. Despite their higher cost, flat interest rates may appeal to borrowers seeking predictability in their monthly obligations.
Benefits of flat rate of interest
- Predictable Repayments: A flat rate of interest offers fixed monthly payments, making budgeting easier for businesses.
- Simple Calculations: With a flat interest rate calculator, borrowers can easily estimate their total loan cost and plan accordingly.
- Short-Term Clarity: This structure provides a clear understanding of interest obligations, especially in the initial repayment period.
- Potentially Lower Initial EMIs: Flat rates may lead to lower equated monthly installments (EMIs) in the early stages of the loan.
Easier Loan Comparisons: The simplicity of flat rates allows for straightforward comparisons between different loan offers.
What is a Reducing Rate of Interest?
Reducing Rate of Interest, on the other hand, employs a method of interest calculation wherein the interest rate applied to the outstanding loan balance decreases as the loan matures. In this scenario, borrowers pay progressively less interest over the life of the loan as the interest component in each payment gradually diminishes.
Consider this example: If an MSME entrepreneur secures a loan with a reducing rate of interest of 6% and an initial principal balance of Rs. 1,00,000, the first monthly payment allocates Rs. 1,50 towards the principal and Rs. 1,00 towards interest. In the subsequent month, with a reduced principal balance of Rs. 98,500, the interest component decreases to Rs. 98.50. This pattern continues until the loan is completely repaid.
Benefits of Reducing Rate of Interest
- Lower Overall Interest Cost: A reducing rate of interest means interest is charged only on the outstanding loan amount, leading to lower total interest paid over time.
- Decreasing EMIs: As you repay the principal, your EMIs decrease, making repayments more manageable.
- Flexible Payment Structure: This rate structure accommodates borrowers by aligning repayment amounts with their cash flow.
- Easy Calculations: Using a reducing interest rate calculator helps borrowers quickly determine their loan’s cost and repayment schedule.
- Incentive for Early Repayment: Borrowers benefit from paying less interest if they repay their loans ahead of schedule.
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Pros and Cons of Flat vs Reducing Rate of Interest
Flat Rate of Interest:
Pros:
- Easy Understanding and Calculation: Flat interest rates are straightforward to understand and calculate, making them suitable for borrowers who prefer simplicity.
- Predictable Payments: Borrowers benefit from predictable monthly payments, as they remain constant throughout the loan tenure.
- Budgeting: Ideal for borrowers who want to precisely plan their monthly financial obligations.
Cons:
- Higher Cost: Flat interest rates are generally more expensive than the reducing rate of interest, resulting in higher overall interest payments.
- Front-Loaded Payments: Monthly payments are higher in the initial years of the loan, which can strain early-stage cash flow.
- Limited Interest Savings: Not the best choice for borrowers aiming to minimize interest costs over the loan’s life.
Reducing Rate of Interest:
Pros:
- Interest Savings: Borrowers pay less interest over the life of the loan, leading to potential long-term cost savings.
- Lower Initial Payments: Initial monthly payments are lower, which can provide breathing room for early-stage businesses.
- Possibility of Larger Loans: Borrowers may qualify for larger loan amounts due to lower initial payments.
Cons:
- Potentially Higher Rate: The interest rate may be higher than that of loans with fixed interest rates.
- Increasing Payments: Monthly payments may increase in the later years of the loan, potentially affecting cash flow.
- Additional Costs: Borrowers may encounter additional expenses, such as closing fees, which can add to the overall loan cost.
How to Calculate EMIs for Flat vs. Reducing Rate of Interest
For borrowers seeking to make informed decisions, calculating EMIs for both flat interest rates and the reducing rate of interest can be empowering. Here’s how to do it:
EMI calculation on Flat Rate of Interest:
Flat rate of interest formula: Interest on every installment = (Total loan amount * loan tenure * yearly interest rate) / total installments. For example, for a loan of Rs 2,00,000 with a fixed interest rate of 10% per annum for a 4-year tenure, the interest amounts to Rs 80,000 (2,00,000 * 4 * 10/100), resulting in a total repayment of Rs 2,80,000.
EMI Calculation on Reducing Rate of Interest:
Reducing rate of interest Formula: Interest on every installment = outstanding loan amount * interest rate applied on every installment. For a loan of Rs 1 lakh at a variable interest rate of 10% per annum for a 5-year tenure, the reducing rate of interest results in progressively lower yearly payments as the outstanding balance reduces with each installment.
Which is Better: Flat or Reducing Rate of Interest?
Choosing between a flat or reducing rate of interest depends on your financial needs. As already discussed above, flat rate offers predictable monthly payments, making budgeting easier, but can lead to higher overall interest costs. It’s straightforward but less flexible, especially if you repay early.
On the other hand, a reducing rate charges interest only on the outstanding loan amount, resulting in lower total interest paid over time and decreasing monthly payments as the principal reduces. This option can save you money in the long run, especially if you plan to repay early. Ultimately, consider your repayment capacity and financial goals before deciding.
Conclusion
Ultimately, the choice between flat interest rates and the reducing rate of interest hinges on individual circumstances and financial objectives. MSMEs contemplating a loan must diligently compare different interest rates and terms to identify the most suitable option for their business. Notably, various Non-Banking Financial Companies (NBFCs), including Kinara Capital, offer collateral-free business loans with reducing rate of interest Kinara Capital extends its support to entrepreneurs with offerings such as working capital loans, asset purchase financing, and specialized loans designed for women entrepreneurs, including the HerVikas program.
Also, we have a dedicated customer support team available between Monday – Friday (9.30 AM – 6.00 PM) at our toll free number 1800-103-2683 for any questions or assistance. This ensures that entrepreneurs can get the help they need throughout the loan process.
FAQs
1. Which is best, flat or reducing interest rate?
Reducing interest rates are generally better because they charge interest only on the outstanding amount, leading to lower overall costs, while flat rates offer predictable payments but higher total interest.
2. Is reducing the rate of interest better?
Yes, a reducing rate of interest is often better as it results in lower total interest payments over time, making it more cost-effective, especially for borrowers who repay early.
3. What is an effective interest rate?
The effective interest rate is the true cost of borrowing, reflecting the total interest paid over a loan’s term, including fees and compounding, expressed as an annual percentage rate.
4. Which is more transparent, flat or reducing rate of interest?
Reducing rate of interest is more transparent as there is clarity in interest calculation, avoidance of hidden costs and it make it easier to compare loans.
5. Which option is better for long-term loans?
For long-term loans, a reducing interest rate is generally better, as it minimises overall interest costs and offers decreasing monthly payments, making repayment more manageable over time.
