Personal Loans

Cost of Loans: Flat Rate vs. Reducing Balance Method

November 18, 2022

Most financial institutions that offer credit to members typically have one thing in common. And that is, they charge borrowers interest. When you take a loan, you agree with the lender that you will also pay interest in addition to the principal (the amount you borrowed).

Interest is the amount the lender charges you when they loan you. Depending on how the interest is structured, it can be a flat rate or a reducing balance rate.

Most borrowers will often overlook the type of interest that lenders offer them. This can often be due to ignorance or because most lenders will often not disclose this information. But the type of interest your lender offers can significantly affect how much you'd have paid back at the end of your loan tenure.

We will use this example to visualise how this may happen.

Two friends, Prisca and Joy, walked into two Saccos, each borrowed Ksh200,000 to be repaid within two years. They were both offered loans at an interest rate of 12% per annum. However, Prisca's interest structure was a flat rate, and Joy's was reducing balance. How much will each of their loans cost?

This article will dive into the difference between a flat rate and reducing balance, how to calculate them, and which structure is cheaper when borrowing money.

Flat Rate Interest

This is the kind of interest that is calculated on the principal loan amount and stays the same throughout the loan tenure. This means that the interest you pay at the start of your loan repayment will be the same as the one you pay on the last month of your repayment. The Equated Monthly Installment (EMI) will stay unchanged.

Flat rate interest is calculated based on prevailing market rates, lender's policy, and borrowers' eligibility. It is a common type of interest structure used by many lenders in Kenya when taking a personal loan or buying a product on hire purchase terms.

How to Calculate Flat Rate Interest

The formula for calculating flat rate interest is:

Interest Payable Per Installment = (P × N × I/100) ÷ N×12

Where;

P = Principal amount

N = Number of Years (N)

I = Interest Rate Per Annum in percentage

N×12 = Number of Installments

Going back to the example above, Prisca borrowed Ksh200,000 at a flat rate interest of 12%p.a to be repaid within two years. How much interest will she pay per installment?

In her case,

P = 200,000

N = 2

I = 12%

N×12 = 24

Therefore,

Interest Payable Per Installment = (200,000 × 2 × 12/100) ÷ 24

(48,000) ÷ 24

Interest Payable Per Installment = Ksh2,000

Note that Ksh2,000 is just the interest Prisca will pay per installment. This will remain unchanged no matter how much she has paid on the principal amount.

To calculate how much will go toward the loan repayment, we need to divide the principal amount (Ksh200,000) by the number of monthly installments (24), which will be Ksh8,333.

Therefore, her EMI (or total monthly payments) will be

2,000 + 8,333 = Ksh10,333.

This means that throughout the loan tenure (2 years), she'll be required to pay a monthly installment of Ksh10,333.

In the end, Prisca will have to repay Ksh247,992. That's almost Ksh48,000 more than she had borrowed as interest.

Advantages of Flat Rate Interest

Simple to calculate compared to reducing balance rate
Easy to track as you make the same repayment every month
Easy to understand for most people as it is straightforward.

Disadvantages of Flat Rate Interest

Interest does not reduce as you gradually pay down your loan.

Reducing Balance Interest Rate

In this method, interest is calculated monthly on the outstanding loan balance. With every repayment installment you make, your outstanding loan decreases. As a result, you only pay interest on the due loan balance.

To better understand reducing the balance rate, think of a savings account, only that in that case, it's called the Effective Interest Rate. The bank will pay you interest on the balance of your account; if your balance drops, interest drops. The opposite is also true.

This type of interest rate method is mainly used for mortgages and credit cards - but is also used by many lenders in Kenya with all commercial banks required to offer customers this structure. Since you will be building equity as you pay your mortgage loan, you will only pay interest on the outstanding balance the lender owes.

On a credit card, you will pay interest on what you've borrowed or owed, not your limit at a given time. If your limit is Ksh20,000 and you borrowed Ksh15,000 but repay Ksh10,000 before the month ends, you will pay interest only on the outstanding balance, i.e., Ksh5,000.

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Calculating Reducing Balance Interest Rate

Calculating this interest rate method is more complicated than the flat rate because the monthly installments you pay will vary.

First, you will have to figure out the loan's initial interest - the interest you'll pay on the first installments.

Joy took a loan of Ksh200,000 at a reducing interest rate of 12%p.a to be repaid in 2 years. Her initial interest will be;

Initial Interest = (P×N×I) ÷ N×12

Where;

P = Principal amount

N = Number of Years (N)

I = Interest Rate Per Annum in percentage

N×12 = Number of Installments

Therefore;

Initial Interest = (200,000×2×12%/100%) ÷ 24

The initial interest will be Ksh2,000 just like Prisca’s

Joy’s lender will then need to do amortization to find the minimum she should repay every month using this formula:

Monthly payments = P((i × 1 + i)^n)/((1+i)^n - 1)

Where;

P = Principal

i = monthly interest rate

n = Number of installment

Therefore;

Monthly payments = 200,000×(((12%÷12)×(1+12%÷12)^(24))÷((1+(12%÷12))^(24)−1)

Monthly Payments = Ksh9,414.69446

On the first month, of the Ksh9,414 Joy will pay, Ksh2,000 will be interest and Ksh7,414 will go toward reducing her loan balance. At the beginning of the second month, her outstanding loan will be Ksh192,585.31 and interest will only be charged on that balance.

Hence, when Joy pays the second installment of Ksh9,414, she will be charged an interest of only Ksh1,925.85 instead of two thousand. Interest will keep diminishing until the last repayment when only Ksh93.21 will go toward interest, and the Ksh9,321.48 will go toward the loan.

During the loan's tenure, Joy will pay 24 installments of Ksh9,321.48. That will amount to Ksh225,952.67. The total cost of her loan will be Ksh25,952.67.

Compare this with Prisca, who was charged a flat rate and paid back a total of Ksh247,992. With reducing balance, Joy was able to save Ksh22,040.

Joy will pay less in interest because every time she reduces her loan balance, her interest diminishes. Here’s a table that shows how interest declines from Ksh2,000 in the first month to Ksh93 in the 24th month. All this happens while her EMI (monthly installments) stays constant, i.e., Ksh9,414

It is also possible for a lender to not amortize the repayments meaning the monthly repayment for each subsequent month will be lower than the preceding month. This is, however, not a common practice.

Advantages of Reducing Balance Method

You only pay interest on pending loan balance - As the principal amount decreases, the interest you pay lowers.
The loan cost can be lower than the flat rate method.

Disadvantages of Reducing Balance Method

It can be harder to calculate and track if you pay nonuniform monthly installments i.e. when loan repayments are not amortized.

The Main Differences Between Flat Rate and Reducing Balance

As shown in the examples above, flat-rate loans charge a uniform interest on the amount borrowed throughout the tenure while reducing balance charges interest only on the unpaid loan balance. The interest in reducing balance keeps changing so does the new principal.

Additionally, calculating interest on the flat rate method is direct as it remains unchanged. Calculating a reducing balance rate is complex as you have to subtract the principal amount from the previous ending balance and the total loan amount to determine how much to pay.

Which is Cheaper? Flat Interest Rate vs. Reducing Balance

The total cost of the loan, that is, interest plus the monthly repayments, can be high on the flat rate method. This comes back to the fact that interest diminishes when you use the reducing balance method.

Which is cheaper of the two methods, will depend on the interest rate your lender is offering you. Reducing balance is cheaper if the interest rate and other loan terms remain the same with the flat rate method. When the rate is high, or the repayment term is longer, the interest on reducing balance will also increase.

Before signing the loan papers, you must calculate how much the loan will cost you. Borrowing Ksh200,000 at reducing balance rate of 12% for two years will cost you Ksh25,952.67, but borrowing it for four years at the same rate could cost Ksh52,804.82.

In that case, you have to examine your repayment ability and whether you can find a different lender with friendlier terms.

WRAPPING UP

The type of interest rate you choose or a lender offers will sometimes only depend on the type of loan you are taking. A person taking an overdraft or credit card debt will only be charged interest with the reducing balance method. Meanwhile, a person taking a hire purchase loan, such as buy now, pay later, will be charged a flat rate.

Most lenders prefer the flat-rate interest method because it increases their profits. But depending on your creditworthiness and the collateral you are willing to put up, you can negotiate from a method that works best for your needs. This can give you the upper hand when taking out a personal or business loan.

Finally, it is essential to note that interest isn't the only charge associated with borrowing. A lender may have different charges depending on the interest method you choose; it is vital that you factor in all these charges when calculating the total cost of a loan.

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Farah Nurow is an experienced Content Writer who enjoys writing creative and educative articles meant to provoke readers' thoughts. He loves sunny weather and thick books. You can connect with him on LinkedIn.