Reducing vs fixed personal loan rates: Know the difference
Due to the lack of collateral requirements, personal loans tend to be a great option to finance your immediate needs. However, you should know the different interest rates based on the bank or lending institution before applying for a personal loan. These interest rates are calculated on the basis of your credit score, loan amount, age, and loan term.
The two methods that are often used to determine loan interest are fixed interest rate and reducing interest rate. You will be required to pay a different amount of interest depending on which method you opt for.
What is a fixed interest rate?
With a fixed interest rate, the rate is constant for the duration of the loan. No matter how much of the original principal has been repaid, it is still calculated based on the entire loan amount borrowed. Effectively, fixed personal loan interest rates continue to be greater than reducing rates.
The main advantage of a fixed interest rate is that your repayment obligation will stay the same for the duration of the loan. You can schedule your repayments at your convenience.
What is a reducing interest rate?
Reducing interest rate, also known as declining interest rate, refers to the fact that interest will be levied on a smaller portion of the loan total. A part of your principal is lowered as and when you make EMI payments, and the remaining amount goes toward interest. The reducing interest rate option uses the outstanding principal balance rather than the initial principal amount to calculate the interest amount.
Difference between reducing and fixed interest rates
Interest rate calculation
In reducing interest rate, the interest rate is calculated depending on the outstanding loan amount and is accrued at a diminishing pace. When interest is calculated on the entire sanctioned principal amount, the interest rate is fixed.
As opposed to reducing interest rate, EMIs for fixed interest rate are higher. This is so because the latter’s interest is based on the initial principal sum. You can use a personal loan EMI calculator to check the different EMI amounts you can opt for and also determine which interest rate type is best for you.
The tenure for a fixed interest rate loan will usually be longer than that for a reducing interest rate loan.
Which is better, reducing or fixed personal loan rates?
Your financial needs and repayment capacity should be considered when deciding between fixed or reducing personal loan rates. A fixed EMI often has lower personal loan rates and a longer payback period, but the instalment is greater because the interest rate is fixed for the duration of the loan and is calculated on the whole loan amount.
Due to the variable nature of the interest rate and the fact that it is based on the principal amount due, which will gradually decline over time, reducing rate EMIs may have lower instalments and shorter repayment terms. You should consider your current financial situation and determine which option will be best suited for you.