Flat rate vs reducing balance: how to compare loans honestly
Two loans with the same rate can cost very different amounts. How flat and reducing balance interest work, with a worked example.
Two loans can advertise the same interest rate and still cost very different amounts. The difference usually comes down to how the interest is calculated: on a flat rate or on a reducing balance. Many borrowers sign loan agreements without realising which method applies, and end up paying far more than they expected. This guide explains flat rate versus reducing balance interest in plain language, with a worked example, so you can compare loans honestly before you borrow.
What is a flat interest rate?
With a flat rate, interest is calculated on the original loan amount for the whole term, even though you are paying the loan back every month. If you borrow 100,000 at a flat rate of 12% a year for one year, the interest is 12,000, calculated as if you owed the full 100,000 for all twelve months. In reality, by the last month you owe very little, but you are still being charged interest on the original amount.
Flat rates are common in some personal loans, car and asset finance, microfinance and informal lending, because they are simple to calculate and the headline rate looks low.
What is a reducing balance rate?
With a reducing balance rate, also called a declining balance rate, interest is charged only on the amount you still owe. As you repay, the balance falls, and so does the interest. Most bank loans, mortgages and SACCO loans use this method, and it is the fairer way to charge interest.
A worked example
Take a loan of 100,000 over 12 months, repaid monthly. The currency does not matter; the maths is the same for shillings, naira, rand or dollars.
At a flat rate of 12%, the interest is 12,000, so you repay 112,000 in total, or about 9,333 a month.
At a reducing balance rate of 12%, the monthly payment is about 8,885, and the total interest is about 6,619, so you repay about 106,619.
The flat-rate loan costs nearly twice as much interest. In fact, a flat rate of 12% over one year works out to roughly the same cost as a reducing balance rate of about 21.5%. As a rough guide, the equivalent reducing balance rate is about 1.7 to 1.8 times the flat rate for loans of six months to five years.
How to compare loans honestly
Ask which method is used. Before signing, ask the lender directly whether the rate is flat or reducing balance, and get the answer in writing.
Ask for the total cost. The most reliable comparison is the total amount you will repay, including all fees, over the full term. If one loan costs 112,000 and another 106,619 for the same amount and term, the choice is clear.
Look for the annual percentage rate. In many countries, lenders must show an annual percentage rate (APR) or total cost of credit that includes fees. This figure allows fair comparisons between different loan types.
Include all fees. Processing fees, insurance and other charges can add significantly to the cost. A loan with a low rate but high fees may be more expensive than one with a higher rate and no fees.
Use a loan calculator
Our loan calculator uses the reducing balance method that most banks use. Enter the amount, rate and term to see the monthly payment and total interest, then compare it with the total repayment a lender quotes you. If a lender's total is much higher than the calculator shows at the same rate, the loan may be priced on a flat rate or carry extra fees.
Borrowing wisely
Understanding how interest is calculated is one part of borrowing well; the other is borrowing only for things that are worth it. Our guide to good debt versus bad debt explains how to decide, and our guide to the digital loan trap shows why short-term app loans are especially costly.
Frequently asked questions
Which is better, flat rate or reducing balance?
For the borrower, reducing balance is cheaper at the same headline rate, because interest is charged only on what you still owe.
How do I convert a flat rate to a reducing rate?
As a rough guide, the equivalent reducing rate is about 1.7 to 1.8 times the flat rate; a loan calculator or the lender's APR gives the exact figure.
What should I ask a lender before borrowing?
Ask whether the rate is flat or reducing, the total amount you will repay, and every fee that applies.
Sources
This article is general information, not financial advice.