Flat Rate vs Reducing Balance: Why the 'Cheap' Loan Isn't
⏱ 2 min readA '10% flat' loan sounds cheaper than a '15% reducing' loan. It usually isn't. Flat rates charge interest on the original loan amount for the whole tenure — even the part you have already repaid — and that accounting trick roughly doubles the effective cost.
The two methods in one sentence each
Flat rate: interest = principal × rate × years, computed on the full original principal regardless of repayments.
Reducing balance: interest accrues each month only on what you still owe — the method banks use for home and most personal loans.
Same 10%, very different bills
Borrow ₹1,00,000 for 2 years at '10%' under each method:
- Flat 10%: interest = 1,00,000 × 10% × 2 = ₹20,000. EMI = ₹5,000.
- Reducing 10%: EMI ≈ ₹4,614. Total interest ≈ ₹10,750.
- The flat loan costs almost twice as much for the same headline rate.
The conversion rule of thumb
For typical 1–5 year tenures, a flat rate is equivalent to roughly 1.8× the reducing-balance rate. So '10% flat' really costs about 18% reducing — useful mental math when a dealer quotes a suspiciously low rate.
Flat rates are most common in vehicle loans, consumer-durable finance and some personal loans. Always ask which method applies and what the APR (annual percentage rate) is.
How to compare two loan offers fairly
Put both offers through an EMI calculator on reducing-balance terms, or simply compare the total amount payable over the tenure. The total rupee outflow cuts through every rate-quoting trick.
Frequently asked questions
Is quoting a flat rate legal?
Yes, but lenders must disclose terms, and comparing the APR or total payable exposes the real cost. Treat any quoted 'flat' rate as roughly 1.8× when comparing to bank loans.
Which method do banks use for home loans?
Reducing balance (also called diminishing balance) — interest is charged monthly on the outstanding principal only.
How do I convert a flat rate to a reducing rate?
Multiply by roughly 1.8 for typical tenures. A 9% flat ≈ 16% reducing. For precision, compute the EMI both ways and compare totals.