When you apply for a loan—whether for a car, motorcycle, or personal use—you will often see two types of interest rates quoted: Flat Rate and Reducing Balance Rate.
Understanding the difference between these two is crucial because they can make a massive difference in how much interest you actually pay.
What is Flat Rate Interest?
Flat Rate interest is calculated on the original principal amount for the entire duration of the loan. It does not decrease as you pay back the loan.
Example:
- Loan Amount: 1,000,000
- Interest Rate: 10% per year (Flat)
- Term: 1 Year
Calculation:
- Interest per year = 1,000,000 × 10% = 100,000
- Total Interest for 1 year = 100,000
- Monthly Payment = (1,000,000 + 100,000) / 12 = 91,667
Even in the last month, when you only owe a small amount, you are still paying interest based on the full 1,000,000.
What is Reducing Balance Interest?
Reducing Balance (also known as Diminishing Balance) interest is calculated on the outstanding balance at the end of each month. As you pay off the principal, the interest amount you pay decreases.
Example:
- Loan Amount: 1,000,000
- Interest Rate: 10% per year (Reducing)
- Term: 1 Year
Calculation:
- Month 1 Interest: 1,000,000 × (10%/12) ≈ 8,333
- Month 1 Payment: 87,916 (Standard EMI)
- Principal Paid in Month 1: 87,916 - 8,333 = 79,583
- New Balance: 1,000,000 - 79,583 = 920,417
- Month 2 Interest: 920,417 × (10%/12) ≈ 7,670 (Lower than month 1!)
Total Interest Paid: ≈ 54,991 (Compared to 100,000 with Flat Rate!)
The "Trap" of Flat Rates
Lenders often advertise Flat Rates because the percentage number looks lower and more attractive.
- A 10% Flat Rate is roughly equivalent to a 17-19% Reducing Balance Rate.
- If Bank A offers "10% Flat" and Bank B offers "15% Reducing", Bank B is actually cheaper, even though 15% sounds higher than 10%.
How to Compare?
Always convert the Flat Rate to an Effective Interest Rate (EIR) or equivalent Reducing Balance rate before comparing.
Our Loan Calculator does this for you automatically! Simply select "Flat Rate" as the interest type, and we will show you the true cost.
Key Takeaway
Never accept a loan based on the "Flat Rate" number alone. Always ask for the Effective Rate or calculate the total interest payable to see the real cost.
Written by Calc Labo Research Team