Flat Rate vs Reducing Balance Rate

Why a loan advertised at a "flat" interest rate costs far more than it seems, and how to convert it to a comparable reducing balance rate.

Some lenders, such as certain vehicle dealers, consumer lenders and informal lenders, quote interest as a flat rate. It sounds cheap, but it can be almost twice as expensive as a similar-looking reducing balance rate.

Flat rate

With a flat rate, interest is calculated on the original loan amount for the entire tenure, even though you repay part of it every month.

Example: a loan of 1 lakh rupees at 12 percent flat for 2 years:

Interest = 1,00,000 x 12% x 2 = 24,000 rupees.
Total repayment = 1,24,000 rupees.
EMI = 1,24,000 / 24 = about 5,167 rupees.

Reducing balance rate

With a reducing balance rate, interest is charged only on the amount still owed, which falls each month. Most bank home loans and personal loans use this method.

For the same EMI of about 5,167 rupees on a 1 lakh loan over 24 months, the equivalent reducing balance rate is about 21 to 22 percent a year, nearly double the advertised 12 percent.

Why the difference

With a flat rate, you keep paying interest on money you have already repaid. Halfway through the loan, you owe only about half the original amount but still pay interest as if you owed all of it.

A quick rule of thumb

For typical tenures, the reducing balance rate is roughly 1.7 to 1.9 times the flat rate. Always ask lenders for the reducing balance rate or the annual percentage rate so you can compare fairly.

Regulation

The RBI requires regulated lenders to disclose the annual percentage rate and give borrowers a key fact statement before signing, making comparisons easier. Informal lenders are not covered, so extra care is needed.

Comparing two offers

A dealer offers a two-wheeler loan at "just 9 percent flat". A bank offers 15 percent on a reducing balance. At first the dealer's offer looks better. After converting, the dealer's loan is roughly 16 to 17 percent on a reducing basis, costlier than the bank's.

Thinking flat and reducing rates are comparable

A flat rate charges interest on the full original amount throughout, so its true cost is much higher than the same number on a reducing basis.

Key takeaways

Flat rates charge interest on the original loan amount for the whole tenure.
Reducing balance rates charge interest only on the amount still owed.
A 12 percent flat rate over two years equals about 21 to 22 percent reducing.
Always compare loans using the reducing rate or APR.