Flat vs Reducing Interest Rate in Loans: Which is Better in 2026

What is a flat interest rate?

When you pay the same interest throughout your loan tenure at a constant rate on the entire loan amount, you have opted for a flat interest rate. It does not consider 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.

If you have taken a business loan for a longer tenure, you should not opt for a flat interest rate as you may end up paying a higher interest rate.

Let's go through the calculations

• Loan Amount: ₹5,00,000
• Interest Rate: 10%
• Loan Tenure: 5 years (60 months)

Formula for calculating the monthly EMI and total interest paid over the loan tenure:

• Annual Interest Amount: ₹5,00,000 * 10% = ₹50,000
• Total Interest for 5 Years: ₹50,000 * 5 = ₹2,50,000
• Total Amount to be Repaid: ₹5,00,000 (Principal) + ₹2,50,000 (Interest) = ₹7,50,000
• Monthly EMI: ₹7,50,000 / 60 = ₹12,500

Total interest paid over the 5 years would be ₹2,50,000.

What is a reducing interest rate?

In the reducing interest rate method, the interest is calculated on the outstanding loan amount, which decreases as you repay the principal. It means, each EMI is split into interest and principal.

As the principal reduces with loan maturity, the interest for the next period is calculated on the new, lower principal amount. Therefore, 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

• Loan Amount: ₹5,00,000
• Interest Rate: 10%
• Loan Tenure: 5 years (60 months)

The EMI for a reducing balance loan is calculated using the following formula:

EMI = [P x r x (1+r)^n] / [(1+r)^n -1]

• P = Principal loan amount (₹5,00,000)
• r = Monthly interest rate (10% annually / 12 months = 0.8333% per month)
• n = the number of monthly instalments (60 months)

EMI = 5,00,000 * 0.008333 * (1+0.008333)^60 / [(1+0.008333)^60 - 1] = ₹10,624

• Total EMI for 1 year: ₹10,624 * 12 = ₹1,27,488
• Total EMI to be Repaid over 5 years: ₹1,27,488 * 5 = ₹6,37,440

Flat vs Reducing Interest Rate – Quick Comparison Table

Here is a quick difference between the two interest rates:

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. It's also important to first check your MSME loan eligibility criteria before applying. 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.

How RBI's Repo Rate Changes Affect Loan Interest Type

The repo rate is the benchmark interest rate at which the RBI lends money to commercial banks. It is a vital tool used to control inflation and stimulate economic growth.

Because commercial banks borrow from the RBI, changes to the repo rate usually trickle down to consumer loans. However, the exact impact on your monthly EMI depends entirely on your loan's interest type.

Flat / Fixed Interest Rates: Zero Impact

The RBI's repo rate decisions have no impact on flat or fixed interest rates. When you opt for a fixed or flat rate loan, your interest percentage is locked in at the time of borrowing. Whether the RBI raises or cuts rates in the future, you keep paying the exact same EMI across your entire loan tenure.

Reducing Interest Rates: Direct Impact

RBI repo rate changes directly impact reducing interest loans, meaning you only pay interest on your outstanding loan balance.

If you are wondering, how it works, the below pointers explain it further:

• When the Repo Rate Increases: An increase in repo rate indicates increased borrowing costs for the banks. This leads to an increase in your monthly EMI or extension of your loan tenure—meaning you pay more interest overall.
• When the Repo Rate Decreases: A fall in repo rates indicates decreased borrowing costs. Your interest rate drops, which translates to a lower monthly EMI or a shorter loan tenure, saving you money.

How can you benefit by choosing the right interest rate?

The interest rate type you choose, helps you define your EMI and the future business growth. Choosing the right interest rate can benefit you in 3 major ways:

1. Better financial planning

When you choose a flat vs. reducing interest rates, you choose it based on the nature of your business, payout history etc. For example, if you have a long-term project going on where you receive or are guaranteed to receive fixed compensation every month, you can opt for a flat interest rate. This takes out the uncertainty of reducing interest rates and you can repay the EMIs on time.

2. Higher cost efficiency

If you are looking for cost efficiency and can bear higher initial EMIs, you should opt for reducing interest rates. The benefit with this is the fact that your EMI is calculated on the outstanding amount. You can work with loan tenure and EMI amount when the interest rates decrease or increase based on which phase of your loan repayment you are at.

3. Improved cash flow management

Cash flow for businesses is the ultimate challenge to conquer. In this context, when EMIs occupy a lot of your financial space, there is a chance that your cashflow suffers. Therefore, you should choose a floating interest rate, especially, when the repo rates are down, to ensure you have a lower EMI burden.

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. Based on the nature of your business, capital requirement, repayment capacity, and cashflow situation, you should consider an interest rate that best suits your requirement. Once you are well prepared, you can apply for business loan online.

Frequently Asked Questions (FAQs)