Two offers for the same loan:
- Lender A: 10% flat
- Lender B: 15% reducing balance
Lender A looks cheaper. It's actually more expensive. Here's why.
How each method works
Flat rate: interest is charged on the original amount, for the whole term.
total interest = principal × annual rate × years monthly instalment = (principal + total interest) ÷ months
Reducing balance: interest is charged each month on the amount you still owe. As you repay, the interest shrinks. The instalment is the standard EMI formula.
Side-by-side example
Loan of 1,000,000, 5 years (60 months).
10% flat:
- Total interest =
1,000,000 × 0.10 × 5 = 500,000 - Instalment =
1,500,000 ÷ 60 = 25,000
10% reducing balance:
- EMI = 21,247 (from the EMI Calculator)
- Total interest = 274,823
| 10% flat | 10% reducing | |
|---|---|---|
| Monthly payment | 25,000 | 21,247 |
| Total interest | 500,000 | 274,823 |
Same "10%", but the flat loan costs about 225,000 more.
Why flat costs more
In the final year of a flat-rate loan you've repaid most of the principal, but you're still paying interest as if you owed the full 1,000,000. Reducing balance charges interest on what you actually owe.
The real rate behind a flat rate
To compare fairly, ask: what reducing rate gives the same 25,000 instalment?
Solving for it gives about 17.3% a year. So a 10% flat rate over 5 years costs the same as a 17.3% reducing loan. That means Lender B at 15% reducing is the cheaper offer.
You can find this in a spreadsheet:
=RATE(60, -25000, 1000000) * 12
Rule of thumb: for 3–5 year loans, the reducing equivalent is a bit under double the flat rate. Use the spreadsheet for an exact figure.
Where you'll see flat rates
- Vehicle loans and two-wheeler finance
- Consumer durables (phones, appliances on instalments)
- Some personal loans and microfinance
Many lenders quote a flat rate because it's the smaller number. Some also show an "effective" or APR figure in the fine print. That's the one to compare.
Prepayment works differently too
With reducing balance, prepaying cuts your future interest straight away. With a flat-rate loan, the interest was fixed upfront, so check exactly how much the lender refunds if you close early. Sometimes it's very little.
Questions to ask any lender
- Is this rate flat or reducing balance?
- What is the APR or effective rate, including fees?
- What's the exact monthly instalment and the total amount payable?
- What happens if I prepay or close early?
If the lender won't give you the total amount payable, walk away.