Flat rate vs reducing rate: why 9% flat is really about 16%

Flat vs reducing: the difference

Flat rate: total interest = loan × rate × years, fixed at the start. Even in the last month, you're paying interest as if you still owed the full amount.

Reducing (diminishing) balance rate: each month's interest is charged only on what you still owe. As you repay, interest falls. Banks quote most home, personal and car loans this way, and it is the basis of the annual percentage rate (APR) in a Key Facts Statement.

Same "8%", very different cost

A ₹2 lakh loan for 3 years:

In month 1 the two loans charge the same interest. By the last month, the reducing loan charges interest on a tiny balance, while the flat loan still charges as if the full ₹2 lakh were outstanding. If the principal is split evenly across EMIs, that last month's flat interest works out to about 288% a year on what you actually owe. The flat-rate loan costs nearly twice the interest overall.

Why lenders quote flat rates

• It is easy to work out at a counter. Dealers, shop finance desks and field staff can give an EMI with one multiplication and one division, without a calculator or a schedule.
• It is the old habit in some segments. Vehicle finance, consumer durable loans and microfinance grew up quoting flat rates, and many sales teams still talk that way.
• It makes the offer look cheaper. A flat number is roughly half the real rate, so it sits well next to a bank's reducing rate on a hoarding or a showroom display.
• It hides fees well. When the rate is already confusing, a file charge or an advance EMI draws less attention.

Three ways to convert a flat rate

1. Rule of thumb. Multiply the flat rate by about 1.7 to 1.8. For 9% over 3 years the exact multiplier is 1.80. Good enough to spot a bad deal in the showroom.
2. From the EMI. Total interest = EMI × number of EMIs − loan amount. Divide by the loan amount and by the years: that is the flat rate, whatever the salesperson called it.
3. In a spreadsheet. In Excel or Google Sheets, =RATE(number of EMIs, −EMI, loan amount) × 12 gives the reducing rate for any EMI. Or enter the quote in the flat vs reducing rate calculator.

Real-world quotes, converted

These are typical shapes of quotes Indian borrowers get. The figures are illustrations, not any lender's offer.

• Bike loan at the dealer: ₹1 lakh, "7.99% flat" for 24 months, plus a ₹2,500 file charge. The EMI is ₹4,833. The rate alone is 14.66% reducing. Counting the file charge, which is taken from the amount you get, the APR is about 17.26%.
• Phone on a consumer loan: "1% per month" flat for 12 months is 12% a year flat, or 21.46% reducing. Compare it with paying in full and keeping any cash discount.
• Used car from an NBFC: "10% flat" for 4 years is 17.6% reducing. A bank loan on a used car at a clearly lower reducing rate would be cheaper.

Fees hurt more on short loans: a ₹2,500 charge on a 2-year bike loan adds far more to the APR than the same charge on a 5-year car loan.

Where flat rates show up

• Two-wheeler and some car loans arranged at the dealer.
• Consumer durable loans for phones, TVs and appliances.
• Some NBFC personal loans and microfinance loans.

Questions to ask before you sign

1. "Is this a flat rate or a reducing balance rate?"
2. "Can I see the Key Facts Statement?" RBI requires lenders to give a KFS for retail loans before you sign. It shows the APR, which includes fees and is comparable across lenders, and the total amount you will repay.
3. "How many EMIs, and are any taken in advance?" Advance EMIs reduce the cash you get but not the loan.
4. "What is deducted at disbursal?" File charges, documentation and insurance all raise the APR.
5. "If I close early, how is the outstanding worked out, and is there a charge?" On some flat-rate loans the outstanding is computed in a way that leaves less interest to save than you expect.

Then compare offers on EMI and total amount payable with the loan offer comparison, or work out a bike loan with the two-wheeler loan calculator.

Frequently asked questions