What is the difference between Reducing Balance and Flat Rate of interest?
In the ‘Flat Rate’ system, the rate of interest on the whole amount is calculated over the entire duration of the loan and the principal, plus the interest is divided over the number of installments. E.g. – If the loan is for Rs. 1,00,000 at the rate of 12% per annum, and the tenure is 24 months, then the interest for 2 years is Rs. 24,000. The EMI will be (100000+24000)/24, which comes to Rs. 5,166.67. But in the ‘Reducing Balance’ system, also referred to as the WDV (the Written Down Value) system, the interest is charged on the outstanding balance of the loan. E.g. – If the loan is Rs. 1,00,000 at 18% for 2 years, then I have to pay an EMI of Rs. 4,919. Now, at the end of the year, I have paid Rs. 4,919*12, which equals Rs. 59,028, and the principal that is outstanding is Rs. 45,700, then in the 2nd year, the interest will be charged on Rs. 45,700 only.