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Differences Between Fixed and Reducing Interest Rates in Business Loan

Differences Between Fixed and Reducing Interest Rates in Business Loan

Whether you need to procure inventory, purchase equipment, or expand operations, a business loan can be an effective way of raising finance to help you meet such business needs.

But before applying for one, you need to analyse several factors such as loan tenure, loan amount and, most importantly, interest rate. And not just interest rates but the kind of interest rates as well. You can choose either a fixed interest rate or a reducing one. But which one will suit your financial plans best? You’ll be able to answer that question after reading this article.

Here we discuss everything there is to know about fixed vs reducing interest rates to help you decide which interest rate is best for your business.

What is a fixed Interest rate?

A fixed interest rate is a type of interest rate that remains constant throughout the loan tenure. In other words, the interest rate doesn’t vary during the loan tenure and remains the same throughout the duration of the loan.

Choosing a fixed interest rate has significant benefits. Here’s a look at them.

1. It remains constant throughout the loan tenure, hence allowing you to plan efficiently.

2. It is easy to calculate.

3. The interest rate is relatively lower compared to reducing the Interest rate.

4. Applicants can get a longer loan tenure.

Here’s a look at some of the shortcomings of fixed interest rates.

1. In case the bank reduces the interest rate, you won’t be able to take advantage of it since fixed interest rate remains constant throughout the loan tenure.

2. While the fixed interest rate might be lower than reducing interest rate, the cumulative interest rate might be higher over the life of the loan.

What is a reducing interest rate?

Reducing interest rate varies as your loan tenure continues. Instead of the principal amount, you use the remaining loan amount to calculate the interest for the subsequent instalments, reducing it as you pay.

Reducing interest rate offers certain benefits to loan seekers. Here’s a look at them.

1. Your interest reduces as you pay.

2. Since the interest rate is charged on the remaining loan amount rather than the principal amount, the cumulative interest rate ends up being lower than the fixed interest rate over the life of the loan.

Here’s a look at some of the demerits of choosing a reducing interest rate.

1. Since the interest rate is calculated on the remaining loan amount, which reduces with each EMI, it can be challenging to calculate this beforehand.

2. Due to the complicated calculations, and ambiguity in interest rates, it can be difficult to make financial plans.

Fixed interest rate vs reducing interest rate

Let us now take a look at how fixed interest rates and reducing interest rates differ.

1. Method of calculation

In case of fixed interest rate, the interest rate is calculated on the principal amount. However, in case of reducing interest rate, it is calculated on the remaining loan amount that is reduced with each instalment.

2. Interest rate

Since the principal amount is used for interest calculations in fixed rate business loans, the interest rate is slightly lower than that of the reducing interest business loan.

3. Loan term

Loan terms for fixed interest rates are usually longer, while those for reducing interest rates are shorter.

4. Ease of calculation

Fixed interest rate instalments are easier to calculate than reducing interest rates, as interest is calculated on the principal amount. In the case of the latter, interest depends on the loan amount that remains to be paid, which reduces with each instalment.

5. Stability of interest rate

There is the stability of interest rate for fixed rate business loans. You can calculate your interest rate and know how much you must pay over the loan tenure. This helps you budget and plan ahead.

For the reducing rate business loan, the interest rate varies with the loan amount that remains to be paid.  

Factors affecting interest rates

Irrespective of whether you opt for the fixed or reducing interest rate, there are certain factors that can affect your interest rate. Here’s a look at them.

1. Your credit score

A high credit score increases your chance of getting a loan at lower interest rate. This is because it convinces the lender of your creditworthiness.

However, if you have a low credit score, you can always work on it by paying your bills on time and building a positive credit history.

2. Business age and financial history

The age and financial history of your business plays a crucial part in determining your interest rate. Financial institutions consider these factors to asses loan risk. The older the business, the lower the interest rate, as it indicates the business’s ability to withstand market conditions.

3. Industry conditions

Lenders also study the industry that your business belongs to. They analyse its future and stability to gauge whether your business will survive and thrive through the loan tenure.

Conclusion

Comparing fixed vs reducing interest rate, reducing interest rate will be the best if you are looking for a short-term loan. Similarly, a fixed rate business loan would be great if you are looking for a long-term one.

But once you’ve decided the type of business loan interest rates that suits you, your next task is identifying a financial institution that is reliable, offers competitive interest rates, flexible loan tenures and quick business loan approvals.

Tata Capital checks all these boxes and offers a smooth application process so that your business goals remain on track. So, take your business to new heights with Tata Capital and apply today!

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