Flat Interest Rate vs. IRR
The IRR and Flat Interest Rates are two different types of methods used by NBFCs and Banks to calculate interest. This blog helps you to understand different aspects of both.
There are several loan products available in the market, and interest rates are a major component when it comes to approving a loan. Be it a personal loan, home loan, car loan, or any other type of loan, The interest rate is something that is charged on the borrowed money no matter how much amount you take as credit from the bank. Since there can be numerous ways to calculate it, the two most common methods used by banks and NBFC companies are Flat Interest rates and IRR.
As you might be applying for a loan, it is crucial to know different types of calculation methods that might result in varying interest rates charged upon the money you have borrowed from them.
Understanding the Calculation of Interest Rates
When banks calculate interest rates, they often use two different methods: the flat interest rate and the internal rate of return or IRR.
The flat interest rate is calculated by the following formula:
(Interest = Principal x Time Period of Loan x Interest Rate/ Total Number of Instalments)
The IRR or Internal rate of return method considers how much money will be repaid if an investment pays back more than it originally borrowed and less than it originally borrowed.
Example to Understand Flat Rate and IRR
In Flat Rate, For instance, you borrow a sum of Rs. 10,000 for purchasing a new two-wheeler. In this case, the bank will charge you 10% Flat Rate over the period of 5 years and you will pay a total of 15000 over the period of 60 months which makes it an EMI of Rs. 250 per month inclusive of interest rate. So, in this, you are paying a principal amount of 10,000 with an interest rate of 10% equated on a monthly basis over the total period of 60 months. In the case of IRR, the bank will give you the same loan amount with 17.30% IRR and here also the equation of calculation for monthly EMIs will be similar but here the interest is calculated based on the reducing rate and not on the basis of the flat rate.
How Does Interest Rate Change?
Flat interest rates are a fixed percentage of the loan amount, while variable interest rates can fluctuate over time. The main difference between flat and variable interest rates is that flat interest rates are often lower than variable interest rates. This is because lenders can predict the exact amount of interest that will be paid over the life of the loan, and can offer a lower rate as a result. However, variable interest rates can sometimes be lower than flat rates, depending on market conditions.
In the scenario of a Flat Interest Rate, the calculation that will happen will be fixed and you have to pay the fixed interest rate calculated on the whole amount but if this is the case of IRR, the interest rate is calculated on the outstanding amount and interest rate applicable on that particular EMI.
What is the benefit of a Flat Interest Rate?
The Flat Rate Interest gives varied benefits and advantages to loan borrowers and gives them a better deal for any kind of loan taken from the bank. Here are some of the advantages which are as follows:
- Transparent
The borrower gets to know in the beginning how much the fixed interest he has to pay on the total borrowed amount. This is a very transparent process and makes dealing very easy for both lenders and borrowers.
- Easier to Understand
Some banks or financial companies may charge hidden amounts while giving loans to consumers and this is something that you as a consumer may not like. In the case of a flat interest rate, the communication regarding the interest rate remains clear and there is no adjusting amount or differentiating amount that you have to worry about on an EMI-to-EMI basis. These loans are good for consumers who are not that financially literate but want access to credit options.
- Makes Repayment Easy
In this format of interest calculation, the repayment is fixed and easy. This makes it easy for the borrower to know how much exact amount he has to pay with every EMI. Since this is the most common form of interest calculation, this is something easy for consumers or borrowers to understand.
What is the benefit of IRR?
Here are some of the benefits it can offer you as a benefit to choosing IRR:
- Interest Rate is Calculated on Outstanding Amount
In the case of IRR, the interest rate is not calculated on the whole sanctioned loan amount but only on the outstanding loan amount which varies as you pay the EMI on a month-to-month basis. Here the calculation of interest happens on the basis of the outstanding amount.
- Borrower Pays Less Interest Rate Over the Period
In IRR, the borrower pays a lesser interest rate over a period of time but in some cases, it might be higher than the interest charged in a fixed interest rate.
Conclusion: Flat Interest Rate vs. IRR
This blog has covered different aspects of how interest rates are charged and how they may change as per the calculation in the case of both types of interest rate calculation methods. In order to conclude, the understanding is that the banks might use these calculations on a case-to-case basis ranging on different loan products. While a Flat Interest Rate can always be seen as an approachable and easy-to-use method of interest rate calculation, the IRR may offer you a lesser interest rate over a period of time which may be a good scenario for the borrower. While both methods are popularly used, it depends on the bank which method to go with and consumers can always choose the lender or NBFC according to it.
