Flat rate vs reducing balance: why a 7.5% flat loan costs almost twice as much
Two loans, both advertised at 7.5% a year, both for USD 20,000 over 5 years, can cost very different amounts. On a reducing balance the total interest is USD 4,045.51 and the payment is 400.76 a month. On a flat rate the interest is USD 7,500 and the payment is 458.33 a month. The flat loan costs 85% more, because it keeps charging interest on money you have already paid back. A 7.5% flat rate is the same cost as a reducing balance rate of about 13.32%. The loan and EMI calculator gives the reducing balance payment, total interest and schedule for any loan, so a flat quote can be set against it on the same footing.
Examples are in USD and PKR. The arithmetic is the same in any currency.
What "reducing balance" means
Interest for each month is charged on the amount still owed at the start of that month. Every payment is part interest, part principal, and as the principal falls, the interest share falls with it. This is the method behind the standard EMI formula and the amortization schedule that banks in most countries print. It is also what an annual percentage rate (APR) describes.
The monthly payment for 20,000 at 7.5% over 60 months is 400.76. The first payment carries 125.00 of interest (20,000 x 0.625%) and 275.76 of principal. The last payment carries about 2.49 of interest. The schedule is 59 payments of 400.76 and a final payment of 400.67, so total interest over the 60 months is 4,045.51.
What "flat rate" means
Interest is charged on the original amount for the whole term, as if no principal were ever repaid.
Total interest = principal x rate x years = 20,000 x 7.5% x 5 = 7,500.
Monthly payment = (principal + total interest) / months = 27,500 / 60 = 458.33.
The payment looks only 57.57 a month higher. Over 60 months that is 3,454.49 more. The bigger problem is that the 7.5% label hides the real cost.
Side by side
| Reducing balance at 7.5% | Flat rate at 7.5% | |
|---|---|---|
| Principal | USD 20,000.00 | USD 20,000.00 |
| Term | 60 months | 60 months |
| Monthly payment | 400.76 | 458.33 |
| Total paid | 24,045.51 | 27,500.00 |
| Total interest | 4,045.51 | 7,500.00 |
| Interest as a share of principal | 20.2% | 37.5% |
| Equivalent reducing balance rate | 7.5% | about 13.32% |
Converting a flat rate to a reducing rate
There is no exact one line conversion, because the answer depends on the term. The reducing balance rate that produces the same monthly payment as a flat rate is found by solving the EMI formula backwards. The loan calculator works on the reducing balance method only, so it does not run that conversion for you. Two rules of thumb help when you are standing in a showroom:
- For terms of 3 to 5 years the reducing balance equivalent is roughly 1.7 to 1.8 times the flat rate. A 7.5% flat over 5 years is about 13.3%. A 10% flat over 5 years is about 17.3%.
- The multiplier eases a little as the term lengthens (about 1.7 at 7 years), but a longer term still adds more flat interest in total, because the flat charge grows with every extra year.
The reverse holds as well. A bank quoting 12.5% reducing costs about the same as a dealer quoting 7% flat on a 5 year term. Compare the total interest, not the headline rate.
A PKR car loan example
Car financing in Pakistan is often described with a flat looking rate on a reducing basis, or with a flat rate on an installment plan, and the two are easy to confuse. Take PKR 3,000,000 over 60 months at 7.5%.
| Reducing balance (PKR) | Flat rate (PKR) | |
|---|---|---|
| Monthly installment | 60,113.85 | 68,750.00 |
| Total interest | 606,830.72 | 1,125,000.00 |
| Difference in total interest | 518,169.28 |
Half a million rupees is the price of not asking which method applies. The loan and EMI calculator takes the amount borrowed (the price minus any down payment), the rate and the term, and shows the reducing balance payment and schedule. The car loan calculator starts one step earlier, from the car price: it takes off the trade in and the deposit, adds the sales tax and any financed fees, and then works out the same reducing balance payment. Which basis a financing agreement uses is stated in the agreement itself. Asking the dealer for the "total markup" figure in writing settles the question quickly.
Where you meet each method
- Reducing balance: bank car and home loans, personal loans from banks, credit cards, most lending that quotes an APR.
- Flat rate: dealer and retailer installment plans, some microfinance and consumer finance, "0% interest" plans where the price has been raised instead, and some informal lending.
Some lenders quote a flat rate and then convert it to an "effective" or "IRR" rate in the contract. The contract rate is the one to compare.
Three questions to ask before signing
- Is the rate flat or reducing? If the answer is "it is the same thing", it is flat.
- What is the total amount I will pay over the term? Divide it by the principal to get the true interest share.
- If I repay early, is the remaining interest refunded? On a reducing balance loan, early repayment saves the interest not yet charged. On a flat loan, lenders often keep most of it.
Anyone offered an EMI plan at a flat rate, in India or elsewhere, can run the reducing balance side of the same check in the loan calculator and compare the totals. The guide on how EMI is calculated shows the reducing balance formula step by step.
What this page does not cover on loans
It explains two interest methods with worked examples. It does not recommend any lender or product, and lenders' own fees, insurance and processing charges change the comparison. Use the total cost figure in the lender's own agreement as the final word.
The reducing balance figures on this page come from the formulas and golden tests of the loan calculator. The flat rate figures and the 13.32% equivalent were worked out for this article with the same formulas.
Work out the reducing balance payment on your own loan with the loan calculator
Flat rate and reducing balance questions
Is a flat rate or a reducing balance rate better for the borrower? At the same headline rate, reducing balance always costs less, because interest is charged only on what you still owe. A flat rate charges interest on the original amount for the whole term.
What is 7.5% flat in reducing balance terms? About 13.32% a year on a 5 year monthly loan. The exact figure depends on the term.
How do I calculate the interest on a flat rate loan? Principal x annual rate x number of years. For 20,000 at 7.5% over 5 years, 20,000 x 0.075 x 5 = 7,500.