How Loan Interest Works

Reducing-balance interest

In a reducing-balance loan, interest each period is calculated on the outstanding balance. As you repay principal, the balance shrinks, so the interest portion of each EMI falls over time. This is how standard EMIs work.

Flat-rate interest

A flat-rate loan charges interest on the full original principal for the entire tenure, regardless of how much you have repaid. Because you are effectively paying interest on money you have already returned, a flat rate is more expensive than the same-numbered reducing-balance rate.

Illustration: flat rate vs reducing balance on ₹3 lakh

A dealer offers a ₹3,00,000 two-wheeler or consumer loan at a "10% flat rate" for 3 years. Interest is charged on the full ₹3 lakh for all three years: 3,00,000 × 10% × 3 = ₹90,000, so the EMI is (3,00,000 + 90,000) ÷ 36 ≈ ₹10,833.

Now ask what reducing-balance rate produces the same ₹10,833 EMI on ₹3 lakh over 36 months. The answer is about 17.9% a year. In other words, a 10% flat rate costs roughly the same as an 18% bank loan — because on a reducing-balance loan you only pay interest on what you still owe, and halfway through you owe only about half.

How to compare two loan offers fairly

1. Insist on the annualised reducing-balance rate (banks call it the effective or annual percentage rate). The RBI requires lenders to disclose it in the key-fact statement.
2. Add processing fees (plus the GST charged on them) and compulsory insurance to the cost, not just the interest.
3. Compare total repayment for the same tenure, not EMI alone — a lower EMI over a longer tenure usually costs more overall.
4. Check prepayment terms; the ability to pay down principal early is worth real money on a reducing-balance loan and worth nothing on a flat-rate loan.

Use the EMI calculator with the reducing-balance rate to see the true schedule, and the Simple Interest calculator to reproduce a flat-rate quote.