Two lenders can quote the same interest rate and charge very different amounts. The difference is usually how the rate is applied: on the original loan amount every month (flat) or only on what is still owed (reducing balance). Here is the same loan worked both ways.
The example loan
- Amount lent: 100,000
- Quoted rate: 12% a year
- Term: 12 months, paid in 12 equal monthly instalments (EMIs)
Flat interest
With a flat rate, interest is worked out once on the full amount for the whole term and added to the loan. 12% of 100,000 for one year is 12,000. The borrower owes 112,000 in total, and spreads over 12 months that is an EMI of 9,333.
The catch is that the borrower is paying the principal back every month, but the interest never shrinks with it. In month 11 they owe very little, yet they are still charged interest as if they owed the full 100,000.
Reducing balance interest
With a reducing balance, each month's interest is charged only on the principal still outstanding. The monthly rate is 12% divided by 12, which is 1%. The EMI that clears the loan in 12 months works out to 8,885.
- Month 1: interest 1,000, principal repaid 7,885, balance left 92,115
- Month 2: interest 921, principal repaid 7,964, balance left 84,151
- Month 3: interest 842, principal repaid 8,043, balance left 76,108
Each month a little less goes to interest and a little more to principal. Over the 12 months the borrower pays 106,619 in total, which is 6,619 of interest.
Side by side
| Flat rate | Reducing balance | |
|---|---|---|
| Monthly payment (EMI) | 9,333 | 8,885 |
| Total interest | 12,000 | 6,619 |
| Total repaid | 112,000 | 106,619 |
| Interest charged on | The full 100,000 every month | Only what is still owed |
A flat rate of 12% costs about as much as a reducing balance rate of roughly 21.5% a year on this loan. The quoted number looks the same; the cost does not.
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What this means for a lender
Neither method is wrong. What matters is that the borrower understands which one they are getting, and that your records use the same method every time. Quote the rate and the method together, show the borrower the EMI and the total they will repay before they sign, and keep the schedule where both of you can see it.
Interest-only loans are a third pattern. The borrower pays only the interest each month and the full principal at the end. The same rule applies: write down which pattern the loan uses.
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