Business Loan Interest Rates: Flat vs. Reducing and How to Choose Wisely

What is a flat interest rate?

A flat interest rate is a type of interest rate where the interest is calculated at a constant rate on the entire loan amount throughout the loan tenure, regardless of the amount you have already repaid.
Let's give you an example. If you take a loan of Rs. 5 lakhs at a flat interest rate of 10% for five years, the interest is calculated on the full amount for the entire period. It does not take into consideration the principal repaid each year.
With a flat rate, the borrower mitigates the risk and impact of changes in economic factors like increase in repo rate by The Reserve Bank of India.
But beware!
While this is easy to calculate, there are some concerns which you need to be cautious of. Since the interest is calculated on the entire principal amount, you end up paying more interest over the loan period, and if the loan tenure is longer, you end up paying a significantly higher interest.

Now let's talk about reduced interest rate

What is a reduced interest rate?

In the reducing interest rate method, the interest is calculated on the outstanding loan amount, which decreases as you repay the principal. This means that each EMI is split into interest and principal, and as the principal reduces as the loan matures, the interest for the next period is calculated on the new, lower principal amount. This means that the interest paid is far less than the flat interest rate and is more cost effective for long-term loans; however, the calculations can be a bit complicated.

Let's go through the calculations

To understand the difference between flat and reducing interest rates, let's consider an example where a loan of Rs. 5 lakhs is taken for a period of 5 years (60 months) at an interest rate of 10%. Now let's compare the total interest paid and the monthly EMIs for both scenarios.

Flat vs. Reducing interest rate

Which one is better and why?

For SMEs, the choice between flat and reducing interest rates depends on various factors, including the loan amount, tenure, and your business's cash flow. Here's a simple guideline:
Short-Term Loans: If you are taking a short-term loan (typically less than 3 years), a flat interest rate might be more straightforward and manageable due to fixed EMIs.
Long-Term Loans: For long-term loans, a reducing interest rate is usually more beneficial as it results in lower overall interest payments and decreasing EMIs, which can be more cost effective and ease the financial burden over time.

Choosing the right interest rate can be extremely beneficial

• Better financial planning
• Higher cost efficiency
• Improved cash flow management

Make an informed decision

While considering a loan for your business, evaluate all options as per your requirements and finance planning before making the final decision. Always ask for a detailed breakdown of the interest payments and EMIs for both flat and reducing interest rates. Just because calculations in flat interest rates are easier, does not mean that's the right choice for you. Take the right advice from your financial advisor.