A dealer offers you ₹3 lakh over three years "at ten per cent". A bank offers you the same ₹3 lakh over three years at fourteen. The dealer's instalment is larger than the bank's and you notice it, but by then the paperwork is out and the delivery is scheduled. Neither party has lied to you. They have quoted two different quantities using the same word, and the arithmetic that converts one into the other takes about a minute and is almost never done at the counter.
You take a three-room floor on rent for three years and agree to hand back one room at the end of each year. At the end of year one you are living in two rooms, at the end of year two in one. The rent never changes, because it was fixed on the day you moved in, against all three rooms.
That is flat-rate interest. It is charged on the amount you originally borrowed, for the full tenure, even though you have been giving the principal back month after month. By the last year you are paying interest on money you repaid two years ago.
Two ways of charging interest
| Flat rate | Reducing balance | |
|---|---|---|
| Interest is computed on | The original amount borrowed, for the whole tenure | Whatever is still outstanding this month |
| As you repay principal | The interest charge does not change | The interest portion of the EMI falls every month |
| Where you meet it | Consumer durable finance, some vehicle and gold loans, many informal lenders | Home loans, most bank personal loans, credit cards |
| The headline number | Looks low, because the base never shrinks | Looks higher, and is measured honestly |
| Roughly equivalent to | Close to double the same figure on a reducing basis, for a fully repaid term loan | Itself — this is the comparable figure |
"No-cost" EMI, taken apart
Nobody lends money for nothing. When a purchase is offered on a no-cost EMI, the interest exists somewhere in the transaction; the question is only which pocket it comes out of and whether you were shown it. There are three ordinary constructions, and they are not equivalent for you.
- 1The discount you would otherwise have received is withheld
The item sells for ₹80,000 on EMI and ₹74,000 to somebody paying outright. You are financing ₹80,000 and the ₹6,000 you did not get is the interest. This is the commonest form and the hardest to see, because you never learn what the cash price would have been unless you ask for it.
- 2Interest is charged and returned as a discount or cashback
The lender charges its normal rate, and the merchant reimburses it. The economics can genuinely be free to you — but the reimbursement is often conditional, sometimes arrives across several statements, and is forfeited if you foreclose the loan early.
- 3Interest is waived and the tax on it is not
Goods and services tax applies to a lender's fees and charges even where the interest itself is exempt. On several schemes the processing fee, and the tax on it, remain payable regardless of the discount. It is a small amount, and it is the proof that the loan was never free.
Getting out early
The cost of a loan is also the cost of ending it, and that is settled in the sanction letter rather than at the counter. The rule that matters most to households: on floating-rate term loans to individual borrowers for purposes other than business, the Reserve Bank does not permit foreclosure or prepayment charges. On fixed-rate loans — which is what most personal, consumer and vehicle finance is — such charges are permitted, are commonly a percentage of the outstanding principal, and often come with a lock-in of some months before prepayment is allowed at all.
- Quoted on a reducing balance, with the annual percentage rate stated in the Key Facts Statement
- Processing fee, documentation and insurance charges itemised in rupees
- An amortisation schedule showing the interest and principal in each instalment
- Foreclosure terms written down, including any lock-in period
- Floating rate where the tenure is long, so prepayment cannot be penalised
- Quoted "at ten per cent" with no mention of the basis
- Charges described as nominal, or bundled into the amount financed
- Only a monthly instalment quoted, with the total never stated
- Foreclosure discussed verbally as "we can always close it early"
- A bundled insurance premium added to the loan, which is then financed at the loan rate
A dealer offers ₹2,00,000 over two years at "8% flat" and a bank offers the same amount over two years at 14% reducing. Which is cheaper, and roughly by how much?
Teen kamre ka floor teen saal ke liye liya, aur tay hua ki har saal ek kamra wapas kar denge. Saal do mein aap do kamron mein hain, teen mein nahi — par kiraya utna hi, kyunki woh pehle din teeno pe tay hua tha. Flat rate isi tarah chalta hai: interest poori original raqam pe lagta hai, chahe aadha principal aap laut chuke ho. Isiliye 10% ka flat quote reducing basis pe kareeb dugna baith jaata hai — aur processing fee usse aur upar le jaati hai.
- Flat-rate interest is charged on the original amount for the whole tenure, however much you have repaid.
- A flat rate is close to double itself on a reducing basis; fees deducted upfront raise it further.
- Ask for the Key Facts Statement and read the annual percentage rate, not the headline rate.
- No-cost EMI hides the interest in a withheld discount, a conditional refund, or the tax on charges.
- Foreclosure charges are barred on floating-rate loans to individuals and permitted on fixed-rate ones.
Mark it done to track your progress through the curriculum.
Common questions
Short, direct answers to what people ask about this topic.
- flat rate and reducing balance difference
- Flat-rate interest is computed on the amount you originally borrowed for the entire tenure, while reducing-balance interest is computed each month on whatever is still outstanding. Because you repay principal every month, a flat rate keeps charging you for money you handed back long ago. For a fully repaid term loan a flat rate works out close to double the same figure on a reducing basis, which is why the two numbers cannot be compared side by side.
- interest charged on the full amount borrowed for the whole tenure is known as
- A flat rate. It is the basis used in most consumer durable finance, a good deal of vehicle and gold lending, and by informal lenders, and it produces a headline number that looks low precisely because the base never shrinks. Reducing-balance interest — used on home loans, most bank personal loans and credit cards — is the comparable figure.
- what is 10 percent flat rate in reducing balance terms
- Close to 18 per cent a year, before any fees. On ₹3,00,000 for 36 months a 10 per cent flat quote produces ₹90,000 of interest and an instalment of about ₹10,833 — the same EMI a reducing-balance loan at roughly 18 per cent would produce. A 2 per cent processing fee deducted upfront pushes the effective rate to around 19 per cent, because you repay on ₹3,00,000 while receiving ₹2,94,000.
- is no cost emi actually free
- No — the interest exists somewhere in the transaction, and the only question is which pocket it comes out of. Most often the cash discount you would otherwise have been given is simply withheld, so you finance the higher price; sometimes the lender charges its normal rate and the merchant reimburses it, conditionally and forfeited if you close early; and goods and services tax on the lender’s fees stays payable even where the interest itself is waived. Asking for the outright cash price is what makes the cost visible.
- can a bank charge foreclosure charges on a personal loan
- On floating-rate term loans taken by an individual borrower for a purpose other than business, the Reserve Bank does not permit foreclosure or prepayment charges. On fixed-rate loans — which is what most personal, consumer-durable and vehicle finance is — such charges are permitted, are commonly a percentage of the outstanding principal, and often sit behind a lock-in of some months before prepayment is allowed at all. The terms are in the sanction letter, which is the document to read before signing rather than when you want out.