Compare flat rate and reducing balance loan interest, and convert flat interest rates to their true equivalent reducing rate APR.
The reducing rate of interest, also called the reducing balance rate, is charged only on the outstanding principal. A flat rate charges interest on the original loan amount for the entire term, even though you repay part of the principal every month. A reducing balance rate charges interest only on what you still owe, so interest falls as you repay. Formulas: • Flat Rate: Total Interest = Principal × Annual Rate × Years; EMI = (Principal + Total Interest) ÷ (Years × 12) • Reducing Balance: EMI = [P × r × (1 + r)^n] ÷ [(1 + r)^n − 1], where r = Annual Rate ÷ 12 and n = Months Because of this, a flat rate looks lower than it is. To compare it with a reducing-balance offer, convert it to the equivalent reducing rate (the calculator above does this for you).
Enter 10% in both the flat and reducing rate fields with a 100,000 principal and a 3-year term to reproduce these figures:
Calculate the EMI under the flat rate, then find the annual rate that gives that same EMI on a reducing balance. A rough rule is to multiply the flat rate by about 1.8, but the exact figure depends on the term. The calculator above gives the exact number.
A reducing rate is always cheaper at the same stated percentage, because interest is charged on a shrinking balance. In the example above, 10% reducing costs 16,161.87 in interest versus 30,000 for 10% flat.
They look lower and are simpler to calculate. They are common in some personal, vehicle and consumer-durable loans. Always ask for the APR or the reducing rate so you can compare offers fairly.
Mortgages and most bank loans use the reducing balance method. Flat rates are more common with some non-bank lenders and dealer financing, and rules vary by country, so check your loan agreement.
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