Interest rates are an important-if not the most important-factor to consider when making a personal loan decision. Categorically, favorable interest rates directly translate to favorable loan terms; unfavorable ones mean the opposite.
Because of how influential interest rates are, it's foundationally important to understand the type of interest a creditor might attach to a personal loan and what that means about how much more you will end up paying above the principal.
Creditors, which can be financial institutions or other credit lending facilities, typically attach two types of interest rates to personal loans:
Fixed or flat interest rate
Reducing or variable interest rate
This article highlights the differences between these interest rates to give you an idea of what each entails.
Let's start with understanding flat and reducing interest rates:
What are Flat and Reducing Interest Rates?
Flat interest rate: A flat or fixed interest rate means you pay the same interest rate on your loan each month; the rate remains unadjusted for inflation and doesn't change over time.
Reducing interest rate: When you have a personal loan with a reducing or diminishing interest rate, how much interest you pay changes monthly based on your principal balance and other factors.
Now that you understand these two types of interest rates, let's delve a bit deeper into their differences:
What Is The Difference Between A Flat and a Reducing Interest Rate?
Fixed and reduced interest rates differ in the following key ways:
1) Interest rates approach
A fixed-rate personal loan means your loan interest and EMI remains fixed throughout its term—from when you take out the loan to when you need to have it paid off (for example, one month).
A reduced-rate personal loan means your interest payment varies monthly based on the principal balance and other factors like inflation rate adjustments, market economics, etc.
2) Loan tenure
The loan tenure is the period in which you will repay your loan.
A fixed-rate personal loan will have a fixed interest rate for the entire loan tenure. Contrastingly, a reducing-rate personal loan may be available with an initial fixed term, but the interest rate changes gradually to mirror the market rate.
A fixed-interest personal loan usually has a longer repayment tenure than a reducing-interest personal loan-but always check with your credit facility provider.
3) The amount used to calculate interest (principal)
The interest rate attached to a personal loan usually depends on the principal-the amount borrowed.
A reducing interest rate personal loan bases this interest on a reducing-principal balance, while a fixed or flat rate interest remains unchanged depending on the original principal balance.
Most lenders offer fixed-rate loans, but to ensure you find a fixed-rate personal loan that will work best for your situation, shop around and compare the terms offered.
Fixed-interest rate personal loans are often more secure than reducing ones because the interest rate remains fixed throughout the loan's tenure.
That makes fixed-interest personal loans ideal for borrowers who want their payments fixed. This interest rate type might also be ideal for those who cannot afford the uncertainty of changing monthly payments.
In contrast, a reducing-interest personal loan has a varying interest rate that can change based on market conditions or factors like inflation. This type of interest rate works best for people who prefer flexibility over security so long as doing so doesn't cost them too much extra money over time (and vice versa).
Knowing what interest rate type you will pay on a personal loan is essential because flat and reducing interest rates differ but often have similar terms and conditions.
You should also be aware of other fees that may apply to your loan and ensure this cost is less than the amount borrowed to save money in the long run.