A flat rate charges interest on the full original loan for the whole term, even as you repay it. A reducing rate charges interest only on what you still owe. So a flat rate costs much more at the same number: 500,000 at 10% flat over 3 years costs 150,000 in interest, the same as a reducing rate of about 17.9%. Always ask for the reducing-balance rate (APR or effective rate) to compare offers.
Car dealers, consumer-finance companies and some personal-loan offers love the word “flat”. The rate looks low, often much lower than the bank’s. The catch is in how the interest is counted, and once you see it you won’t compare those two numbers again.
How a flat rate works
Interest is calculated once, on the full amount borrowed, for the whole term:
Total interest = Loan × flat rate × years
500,000 at 10% flat for 3 years: 500,000 × 0.10 × 3 = 150,000. Add it to the loan and divide by 36 months: 650,000 ÷ 36 = 18,056 a month.
The problem: by the last year you owe only a fraction of the loan, but you’re still paying interest as if you owed all 500,000.
How a reducing rate works
Interest is charged each month on the outstanding balance only. As you repay, the interest falls. This is the standard EMI method; our guide to how EMI is calculated shows the formula.
500,000 at 10% reducing for 3 years gives an EMI of about 16,134 and total interest of about 80,800.
Same “10%”, very different cost
| 500,000 over 3 years | Monthly payment | Total interest |
|---|---|---|
| 10% reducing | 16,134 | about 80,800 |
| 10% flat | 18,056 | 150,000 |
| Reducing rate with the same cost as 10% flat | 18,056 | 150,000 at about 17.9% |
So “10% flat” over three years is really about 17.9% in the terms banks normally use. Over five years, 10% flat works out to roughly 17.3%.
A quick rule of thumb
For terms of two to five years, the equivalent reducing rate is a little under double the flat rate, roughly 1.7 to 1.8 times. It’s rough, but it’s enough to spot a bad deal in the showroom:
| Flat rate | Term | Approximate reducing rate |
|---|---|---|
| 8% | 5 years | about 14.1% |
| 10% | 3 years | about 17.9% |
| 10% | 5 years | about 17.3% |
| 12% | 2 years | about 21.6% |
How to convert any flat offer yourself
- Work out the flat monthly payment.
(Loan + loan × flat rate × years) ÷ months.
- Open a reducing-balance calculator.
Enter the same loan amount and term in a loan calculator.
- Adjust the rate until the payment matches.
The rate that gives the same monthly payment is the real reducing rate.
The one question to ask
“What is the APR, or the effective annual rate on a reducing balance?” Reputable lenders can answer it. Also ask for the total amount repayable, including fees, insurance and any processing charges. That single number makes comparisons honest.
A real-world comparison: two car loan offers
You need 1,500,000 over 5 years. The dealer’s finance partner offers 10% flat. Your bank offers 15% on a reducing balance. The dealer’s number looks a third cheaper. Here’s what each costs:
| Offer | Monthly payment | Total interest |
|---|---|---|
| Dealer: 10% flat | 37,500 | 750,000 |
| Bank: 15% reducing | about 35,685 | about 641,100 |
The bank loan is about 109,000 cheaper, despite the “higher” rate. Before deciding, add any processing fees, insurance and dealer discounts to both sides; a cash discount for not taking dealer finance can change the picture again.
Is a flat rate ever fine?
A flat rate isn’t dishonest in itself. It’s just a different way of stating the price. A flat-rate offer can still be the cheapest option if its real reducing rate beats the alternatives. The danger is only in comparing a flat number with a reducing number as if they meant the same thing.
Frequently asked questions
What is the difference between a flat and a reducing interest rate?
Is a flat rate cheaper than a reducing rate?
How do I convert a flat rate to a reducing rate?
Which loans use flat rates?
What should I ask a lender to compare offers?
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Reducing-balance EMI, total interest and a full schedule. Calculated on your device.
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