When you avail a loan, the bank or financial institution charges you interest on the amount borrowed. Hence, before you apply for credit or take a mortgage, it’s important that you understand how this interest is calculated. When you opt to take a loan for a particular tenure, you will be required to repay not just the borrowed amount but also the interest on it. Whether this interest is calculated on a flat or reducing (also called diminishing or effective interest rate) basis is crucial will determine your repayment amount throughout the loan tenure. Understanding key differences between the two modes of interest calculation will help you find the deal with the lowest interest payment.
With the flat option, the interest rate does not change over time. Hence, the amount of payable interest does not decrease as the loan is paid off periodically. Flat rate interest plans are therefore easy to calculate as they simply consider the interest rate and multiply it by the entire loan amount. The number thus calculated is then divided throughout the tenure of the loan. They are also considered quite risk-free as interest rates stay unaffected by changes in the lending market.
The interest payment on a reducing balance loan, on the other hand, is calculated based on the remaining principal amount of the loan. With each payment, a portion of the payment goes toward the principal. The principal amount decreases, hence causing the amount of the interest on each payment to decrease as well.
Let’s consider the two methods with an example. In the flat rate system, as we saw earlier, the rate of interest on the entire amount is calculated over the entire duration of the loan. The principal and the interest are then divided over the number of installments payable. For instance, if you take a loan of AED 200,000 with a flat rate of interest of 10% p.a. for 5 years, then you would pay AED 40,000 (principal repayment @ 200,000/5) + AED 20,000 (interest @10% of 200,000) which is equal to AED 60,000 every year or AED 5,000 per month. Over the tenure of the loan, you would end up paying AED 300,000 (5,000 * 12 * 5). Thus in this example, a monthly payment of AED 5,000 translates to an effective interest rate of 17.27% p.a.
However, if instead of a 10% p.a. flat rate (as in the above example), interest is charged at 10% p.a. reducing balance rate, then the monthly amount would reduce with every repayment. So, the first year you would pay AED 20,000 as interest, the next year you would pay AED 16,000 on a reduced principal of AED 160,000 and so on, till the last year, you pay only AED 4,000 as interest. Now you would have paid back AED 200,600 instead of AED 300,000 as in the earlier case.
So, which one is better – the flat – or the reducing rate? A good rule of thumb to understanding your loan offers is that if the current interest rate in the market is low, opting for a fixed rate might be beneficial. However, reducing rates are useful if the current interest rates in the market are high. Also remember to account for any upfront processing fees while comparing flat and effective interest rates.