Money

The difference between flat and reducing interest rates

coins-948603_1920

The term ‘interest rate’ is one of the most commonly used phrases in consumer finance and fixed-income investments. When you’re applying for a loan – whether it’s a car, personal or home loan – one important thing to keep in mind is the type of interest rate you choose.

There are two different types of interest rates applied to loans – flat rates and reducing rates.

A flat interest rate is an interest rate calculated on the full original loan amount (the principal) for the whole term without taking into consideration the reduced amount of debt. To put that simply, the flat interest rate is charged on the full amount of the loan throughout the loan tenure. For example, if you apply for a loan of AED 100,000 for five years at 5%, the interest paid each year will remain at 5% of AED 100,000 – regardless of how much you reduce the loan.

RELATED: Higher interest rates no problem for UAE residents

Over the five years you would be paying back AED 25,000 in interest (100,000 x 5% = 5,000 and 5,000 x 5 = 25,000).

The flat rate is usually the lowest rate when you’re looking at a loan, however it’s usually misleading. Having a loan where you pay flat rate usually turns out to be more expensive, although the interest rate appears lower. Because the interest doesn’t decrease over time, it becomes more expensive.

A reducing rate (also known as a reducing balance rate), as the term suggests, is an interest rate that is calculated every month on the outstanding loan amount. Each time you make a repayment on the loan, the interest rate will decrease. Basically, the interest for your next loan payment will be calculated based on the updated unpaid loan amount.

If we use the same example of a five-year loan at AED 100,000 at a 5% reducing balance rate and in order to pay back the amount in five years, let’s say you pay AED 20,000 each year. So, your initial interest rate would be calculated off AED 100,000 and the first year you would be paying AED 5,000 in interest (100,000 x 5% = 5,000). Meaning the next year, the reducing balance rate would be calculated off AED 80,000 (100,000 – 20,000) (8,000 x 5% = 4,000). In year three your loan balance would be AED 60,000 and the interest rate would then be based off that principal (60,000 x 5% = 3,000). And every year you pay off AED 20,000 the calculation would be repeated off the reduced amount.

Leaving you to pay AED 15,000 in interest over the five years.

SEE ALSO: Compound interest explained

If the maths seems to be too complicated then don’t worry, there are plenty of online loan calculators that can show you how much you would pay over your loan tenure.

Depending on what kind of loan you’re applying for, it depends on what type of interest will be added to it. Usually, flat interest rate is used for microfinance – small amounts taken out as personal loans or car loans – simply because advertising a fixed interest rate is an easy way for banks to increase their income without giving clients the impression that their prices are more expensive. And because the interest is calculated on the same number each month, you’re able to understand what you’re paying each month as the calculation is easier to understand.

Undoubtedly, a reducing balance rate is better from the perspective that you won’t be paying back as much in interest. But if you apply for any type of loan, it’s important to read the fine print and not to be distracted by the low interest rate.

Now you understand the different interest rates and if you’re looking for a loan then visit our site to compare the best personal loans in the UAE!

To Top