When shopping for a loan, one of the key factors to consider is the interest rate. Some financial institutions will offer you a “Flat Interest Rate” and others, a “Reducing Balance Rate” or both when applying for a loan. These two options as you will come to understand, are relatively simple to understand. Do not solely rely on the bank to do all the calculations for you. Or allow them to drive you to make a decision that doesn’t serve you.
That said, it’s best to stay informed on these financial terms. Here’s our explanation of what flat interest rates and reducing the balance interest rate are, their calculations and their differences, made simple to help you manage your own finances.
Related: How to Manage Debt Better
What is a Flat Interest Rate?
A flat interest rate is an unchanging interest rate charged on liability i.e a loan or mortgage. The interest rate and the amount payable remain constant throughout the duration of the loan and thus overlook the fact that the equated monthly instalments lower the principal amount. Thus, over the tenure of the loan, the interest rate is consistently estimated based on the entire principal amount.
This is how it is determined.
How to Calculate the Flat Interest Rate
It is relatively simple to calculate flat rate interest costs for a loan. You will need the following:
- The loan amount i.e. principal
- The interest rate per annum
- The loan repayment period i.e. number of years or loan tenure
Formula:
Interest Instalment =(Principal x interest rate per annum x number of years)/number of instalments
Let’s apply.
For example, let’s assume that you take to a Personal Loan for Ksh 1,000,000 for a period of 5 years (60 months, which translates to 60 instalments for that period) at a flat rate of 12% per annum.
You must pay –
Interest payable per instalment = Ksh 1,000,000 (principal) * 12% (flat interest per annum) * 5 (no. of years) / 60 (no. of instalments) = Ksh 10,000 per month in interest instalments.
This means that after adding your principal components (principle/number of instalments), your equated monthly instalment would be Ksh 26,666.67 per month. Therefore, during the entire duration of your loan, you will pay a total of Ks 1,600,000.
Benefits of Flat Interest Rate
Easy Calculation
The flat rate interest method makes calculations simple. It allows for greater transparency in loan agreements. Both the lender and the borrower can easily calculate the rate with ease. The calculations are made even simpler due to the equated monthly instalments. This is particularly so when calculating the long-term cost of borrowing. With a few bits of information (loan amount, interest rate and loan repayment period), anyone can easily and accurately calculate.
Predictability
Using the flat rate method you can effectively plan your monthly finances because the equated monthly instalment does not change from month to month. By doing so, flat rate interest provides hustle-free planning and payment.
Lower Rates
In general, flat interest rates are more attractive when interest rates are lower. Therefore, typically employed more on lower interest rates than reducing balance rates.
What is Reducing Balance Interest Rate?
A reducing balance interest rate is an interest rate that is determined monthly based on the amount of the outstanding loan balance. As such, only the amount of the outstanding loan is used to determine the interest for the subsequent month.
The equal monthly instalment for a reducing balance loan includes both the principal repayment and the payable interest on the outstanding loan balance. Where the payments lower the amount of the loan that is still due.
It is relatively simple to calculate flat rate interest costs for a loan. You will need the following:
How to Calculate the Reducing Balance Interest Rate
To calculate the reducing balance interest rate on a loan, you will need the following:
- The outstanding balance i.e. remaining loan amount
- Interest rate
Formula:
Interest payable/instalment = Remaining loan amount * Interest rate per instalment
Let’s apply.
Suppose a case where you take out a Ksh 1,000,000 loan for 5 years at 12% per annum, reducing the balance rate. The monthly equated monthly instalment (EMI) is Ksh 22,244.45. This EMI consists of a percentage of the principal amount that is to be repaid as well as an interest component.
Now, in the first month, 12% is charged on Ks 1,000,000 principal amount. Out of the total EMI of Ksh 22,244.45, the first month’s interest component in the monthly instalment is $10,191.78. The remaining Ksh 12,052.67 goes towards the repayment of the principal. Therefore, at the end of the first month, the remaining balance becomes Ksh 987,947.33 (Ksh 1,000,000 – Ksh 12,052.67)
In the second month, 12% is charged on a reduced balance of Ksh 987,947.33. The interest of the EMI becomes Ksh 9,094.53. The remaining Ksh 13,149.92 goes towards the repayment of the principal amount. This continues in the following months until the repayment of the loan is fully completed.
Benefits of Reducing Balance Rate
Over time, the interest paid is less compared to loans with flat interest rates. This is because interest is only calculated based on the outstanding loan amount. Additionally, a loan with a decreasing interest rate though might have a longer tenure, but it gives greater repayment flexibility.
Difference between Flat Interest Rate and Reducing Balance Interest Rate:
- In the flat interest rate, the loan’s principal amount is used to calculate the interest rate. While as with the reducing balance rate method, the outstanding loan balance is used as a base to calculate interest each month.
- The repayment liability remains fixed with the flat interest rate, while with the reducing balance it keeps varying.
- Interest calculations using the flat interest rate method result in higher equated monthly instalments, while as the reducing balance interest rate results in diminishing interest over time as repayment instalments are made.
- The flat interest rates are typically lower than reducing balance rates.
- Calculating the reducing balance rates is more difficult than calculating the flat interest rate, which is quite straightforward.
- Overall, when comparing the two, the reducing balance rate is a better alternative.
FAQs
How interest rates are determined?
The Central Bank of Kenya (CBK) sets the repo rate, which is the rate at which commercial banks borrow from CBK. Based on this rate, banks issue their lending rates.
How can I know my EMI before taking any loan?
Before taking any loan, know your equated monthly instalments (EMI). It is advisable that you completely understand your amortisation schedule for your loan. Consider your loan amount, intended tenure and interest rate offered. For ease of calculations, consider using a free online EMI calculator.
Flat interest rate or reducing balance method, which is better?
The decision on which is better is subjective. The decision on which is better should be based on your personal financial requirements and repayment capacity. Overall, you will end up paying less interest under the reducing balance method. But with the late interest rate loan, the tenure is shorter as you will end up repaying the loan faster.
Related: Reducing Balance vs. Simple Interest Loans – Which is Better?
Wrapping up: Which One Saves You Money?
Though flat interest rates are easy to understand, easy to calculate and often offer lower interest rates, they may not be as advantageous. The Reducing balance interest rate will save you money overall. When offered both options by your service provider, it is always wise to add all the interest payable during the duration. This is the best method for comparing the true cost of a loan.