Whenever you borrow money against a loan, you pay interest on the amount borrowed. Interest accumulates throughout the loan’s lifetime, which means the faster you repay your loan, the less interest you will end up paying overall.

Loans can calculate interest using either the flat rate method or the reducing balance method. It’s important to know which method your lender uses to calculate interest because there is a big difference between the two methods. This guide will help you understand how flat rate and reducing balance loans work.

Flat Rate Interest vs Reducing Balance Interest

What Is a Flat Rate Interest

With a flat interest rate loan, interest is charged on the full loan amount for the entire repayment tenure. Even as you continue repaying the loan, and the principal outstanding starts to go down, the interest amount stays the same.

For example, if you borrow $10,000 over a 5-year repayment tenure at 10% interest, your monthly repayments will be $212.48.

Flat rate interest results in you paying more interest because you continue to pay interest on the entire loan amount, even after you have paid portions of the principal outstanding.

What Is a Reducing Balance Interest Rate

With a reducing balance loan, interest is charged on the amount you have yet to repay. As you continue repaying the loan, the principal outstanding goes down, which means you pay less interest over the loan’s lifetime.

This means that the actual amount of interest you pay decreases over the loan’s tenure.

Because it charges interest on the amount borrowed rather than the original principal, the reducing balance method gives you a lower overall borrowing cost.

Why Does It Matter?

Borrowers often look at loans based on interest rates alone. Two loans might have the same interest rate but depending on how interest is calculated, you could end up paying vastly different amounts.

Knowing how the interest rate on your loan is calculated will help you determine how much you’ll likely pay over the life of the loan before you accept a loan offer.

How Does a Flat Rate Loan Work?

A flat rate loan calculates interest based on the entire loan amount sanctioned to you for the full repayment tenure of the loan. Your Equated Monthly Instalment (EMI) will typically remain unchanged throughout the loan.

Flat rate interest loans charge interest on the original principal even as you continue paying back the loan. This means that you end up paying interest on money that you’ve already repaid.

How Does a Reducing Balance Loan Work?

With a reducing balance loan, every repayment you make goes towards reducing your principal outstanding. When it comes to calculating interest, lenders will only consider the remaining loan amount that you haven’t yet paid back.

As a result, the interest you pay gets smaller as you continue making repayments, while the amount towards your principal increases.

Total Borrowing Cost: Flat Rate Vs Reducing Balance

Flat rate loans sound great because the interest rate seems lower, but because interest on a reducing balance loan gets smaller as you repay your loan, you end up paying less interest overall.

Advantages of Reducing Balance Interest Rate Loans

Since reducing balance interest loans allow you to pay less interest over the lifetime of your loan, here are some benefits:

As you can see, when comparing loans, it’s always a good idea to compare the total amount you will end up paying rather than just looking at the interest rate.

Which Loan Should I Choose?

For most borrowers, reducing balance loans are cheaper than flat rate loans. This is because as you continue to repay the loan, interest is only calculated on the amount you haven’t yet repaid.

This rewards you for making your repayments by reducing the amount of interest you’ll have to pay going forward.

Which Loans Use These Methods?

Just like loans can use different interest calculation methods, lenders can also use different methods.

When considering a loan, make sure to ask your lender which interest calculation method they use. It’s always best to know this information upfront so you don’t get confused when comparing loans from multiple lenders.

Questions to Ask

If you’ve decided on a lender and are about to accept a loan offer, here are a couple of questions you should ask:

Can you provide me with a repayment schedule?

How is interest calculated?

Asking these questions will help you understand how your loan repayments will be structured. This allows you to plan ahead and avoid any surprises down the road.

Mistakes to Avoid When Borrowing

When applying for loans, many borrowers make the following mistakes:

To avoid the mistakes above, try to borrow responsibly by doing your due diligence on each loan offer.

Loan Calculator

To better understand how much you’ll pay in interest with each interest calculation method, try using a loan calculator.

Loan calculators allow you to quickly estimate your monthly EMI, total interest you’ll pay and total amount you’ll borrow based on the loan amount, tenure and interest rate.

Review Your Loan Offer

Remember that the interest rate is just one part of the loan offer. There are other factors like processing fees, prepayment fees, late payment fees and more.

By looking at the entire loan offer, you’ll have a better idea of which loans are cheaper.

Conclusion

When it comes to borrowing, always know the difference between flat rate interest and reducing balance interest loans. By doing your research and understanding how much you’ll end up paying back, you can borrow smartly and minimize your cost of borrowing.

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