There are two varieties of most loans. Loans with flat interest rate and ones with reducing balance interest rate. Now lenders might or might not offer this choice to borrowers. But if you were given a choice between the two, which one will you choose?
If you know the difference between the two, then there is not much to tell you here. But if you don’t, we use a small example to help clear the difference.
A loan having flat rate of interest is one where interest remain constant throughout the loan tenure. Suppose you take a loan of Rs 10 lac at 8% for 3 years. Now the interest amount every year will be fixed at 8% of the ‘original’ principle, i.e. Rs 10 lac – which works out to be Rs 80,000. And this is irrespective of the fact that you are repaying a part of the outstanding principle every year.
Reducing balance loans are other option. Here the interest is fixed at 8% (like in above example) but not on the original outstanding principle. This is logical as your outstanding principle is reducing every year. So interest is calculated on the reduced outstanding amount every year. As you would have rightly guessed, this naturally leads to lower interest charges during the full personal loan tenure.
So for the same given interest rates, going for a reducing balance Interest rate makes more sense. But that is obviously if you are given a choice. Also, if the two loans on offer also have different rate of interests, then you need to do some mathematics to arrive at the right answer. But simply speaking, the reducing balance EMI seems a better option, as the interest is charged only one the outstanding principle amount.