Flat rate vs reducing balance interest: why 10% flat costs more
A 10% flat rate loan costs far more than a 10% reducing balance loan. A worked example, the equivalent reducing rate, and how to compare loan offers fairly.
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Tools for this job: EMI Calculator · Loan Calculator
Personal loans, vehicle loans and consumer finance are sometimes advertised at a “flat” rate, while home loans and most bank loans use a “reducing balance” rate. The two numbers look comparable and are not: a flat rate of 10% costs roughly as much as a reducing rate of 18%.
How each method charges interest
- Flat rate: interest is calculated on the full original loan for the whole term, even though you repay part of it every month.
- Reducing balance: interest is calculated each month on what you still owe. As the balance falls, so does the interest.
Worked example: 5,00,000 for 3 years at 10%
| 10% flat | 10% reducing | |
|---|---|---|
| Total interest | 1,50,000 | 80,809 |
| Monthly payment | 18,056 | 16,134 |
| Total repaid | 6,50,000 | 5,80,809 |
Flat interest is simple: 5,00,000 × 10% × 3 years = 1,50,000, spread over 36 payments. The reducing figures come from the standard EMI formula. The flat loan costs almost twice as much interest at the same headline rate.
The equivalent reducing rate
To compare a flat offer with a bank loan, find the reducing rate that gives the same monthly payment. For the example above, a payment of 18,056 on 5,00,000 over 36 months matches a reducing rate of about 17.9%. As a rough guide, for terms of two to five years a flat rate is equivalent to a reducing rate about 1.7 to 1.8 times as high: 10% flat is roughly 17–18% reducing. The exact figure depends on the term.
You can find it by trial with the EMI Calculator: enter the loan and term, then adjust the interest rate until the EMI matches the flat loan's payment.
How to tell which one you are being offered
- Look for the words “flat”, “add-on” or “simple interest on the principal” in the offer.
- Ask for the total amount payable and the APR or annual percentage rate. Regulated lenders in many countries must disclose it, and it reflects the true cost.
- Multiply the monthly payment by the number of months and subtract the loan. If the interest equals loan × rate × years, it is flat.
Why flat rates exist
Flat interest is easy to explain and calculate by hand, which is why it persists in dealer finance and small lenders. It also makes the rate look lower than the true cost. There is nothing wrong with a flat-rate loan if you know its real cost and it is still the best option; the problem is comparing it with a reducing-rate loan as if the numbers were the same.
Early repayment
Paying a flat-rate loan off early often saves less than expected, because some lenders front-load the interest in their schedules. Ask how the settlement figure is worked out before assuming you will save the remaining interest. On a reducing-rate loan, early repayment saves interest directly, as shown in prepaying a loan.
For how the reducing-balance EMI formula works, see how EMI is calculated. To see the full schedule month by month, use the Loan Calculator.