Flat Interest vs Reducing Interest Rate

A flat interest rate calculates interest on the original loan amount throughout the loan tenure, resulting in an equal monthly payment. On the contrary, a reducing interest rate re-calculates interest based on the decreasing outstanding balance, leading to lower interest costs over time.

What is a Flat Rate and Reducing Rate?

Flat rate vs reducing rate — which option to choose from?

To help you out, we will first understand the definitions of these interest rate types and look into their features.

Flat Interest Rate

A flat interest rate calculates interest on a loan where the interest is applicable on the entire loan amount throughout the loan tenure.

For instance, if you borrow AED 100,000 with a flat rate of 5% per year for 5 years, you pay 5,000 AED in interest each year. In 5 years, the total interest amount will be AED 5,000 x 5 = AED 25,000. Note that this interest amount is regardless of how much of the loan you’ve already repaid.

What are the Benefits of Choosing a Flat Interest Rate?

Here are the primary advantages of selecting a flat interest rate -

Simplicity and Predictability

Flat interest rates are straightforward to understand and estimate. As a borrower, you know exactly how much interest you will pay over the life of the loan.

Fixed Repayment Schedule

The consistency of a flat interest rate means you have a fixed repayment schedule. This can be quite useful in financial planning and managing expenses.

Ease of Comparison

With a flat interest rate, it is easier to compare loan offers from different banks and lending institutions because the interest calculation method is uniform and clear.

Transparency

There is no confusion about how much interest is being paid at any point in time. You can clearly see the total interest cost upfront.

Attractive for Certain Borrowers

For those who prefer fixed, unchanging costs, a flat interest rate offers financial satisfaction as they don’t have to worry about fluctuating payments.

What is a Reducing Interest Rate?

A reducing interest rate calculates the interest on a loan only on the remaining loan balance. As you repay the loan, the interest also decreases with the decrease in the outstanding amount.

Suppose you have borrowed AED 100,000 with a reducing rate of 5% per year, the interest for the first year is AED 5,000. In the second year, if the balance is AED 70,000, the interest will be AED 3,500 (5% of AED 70,000).

This method often results in lower total interest payments compared to flat interest rates. It can also be useful if you plan to pay off the loan before its tenure.

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What are the Benefits of Choosing a Reducing Interest Rate?

Reducing interest rates on personal loan offers several significant benefits:

Lower Monthly Payments

The reducing rate decreases the monthly instalment amount, making the loan more affordable and easing your financial burden.

Cost Savings

You pay less in interest throughout the loan tenure, which leads to considerable savings. This is particularly relevant for large loan amounts.

Improved Cash Flow

With lower monthly payments, you can actually save more on your income. This money can be used for other essential expenses or investments.

Debt Repayment Acceleration

Savings from lower interest rates can be used to pay off the principal faster. This can reduce the overall loan term.

Enhanced Financial Stability

Reduced financial strain from lower interest payments can improve your overall financial health, reducing the risk of default.

In a Nutshell

With the comprehensive points discussed above, you must have understood the difference between flat rate and reducing rate. Flat interest rates provide consistent monthly payments but often result in higher overall interest costs. Reducing interest rates, meanwhile, offer decreasing interest payments as the loan balance decreases, leading to potential savings.

To make a choice with respect to flat rate vs reducing interest rate, you must understand your financial situation and repayment capacity. For instance, if you want stable fixed interest, you can go for flat rates. However, if you want to clear the loan before the loan period, you can go for reducing rates.

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