Don't be Deceived by Flat and Reducing Rates

Don't be Deceived by Flat and Reducing Rates

For those of you who are looking for a loan in the near future, whether it is an auto loan, home loan or personal loan, one important thing to keep in mind is the type of interest rate you choose. There are two types of rates which can be applied to loans known as the flat rate and the reducing rate.

Would you prefer an auto loan with an 8% interest rate calculated on reducing balance, or a 5% flat rate?  The differences between the two are important to understand in order to make an accurate and relevant comparison.

A flat interest rate means that the amount of interest paid is fixed and does not reduce as time moves on. In other words, the amount of payable interest does not decrease as the loan gets paid off each month. This allows for an easy calculation of interest payments. Take for example a five year loan for a principal amount of AED 100,000. The yearly interest rate on this amount is 10%. To calculate the yearly payment of both interest and principal, you would simply do the following:

 

Year Outstanding Balance at Year End Principal Paid Interest Paid Yearly Payment
0 100,000  
1 80,000 20,000 10,000 30,000
2 60,000 20,000 10,000 30,000
3 40,000 20,000 10,000 30,000
4 20,000 20,000 10,000 30,000
5 0 20,000 10,000 30,000
5 Year Total   100,000 50,000 150,000

                                                                    

As the above calculations show, the yearly payment amount on the AED 100,000 loan with a 10% annual interest is AED 30,000. Over the life of the loan, AED 150,000 will be paid back to the lending institution. 

The reducing interest rate on the other hand means that as a payment is made on the principal amount of a loan, the interest payment reduces as well. Let’s look at the same example as before except with a reducing rate of 10%: 

 

Year Outstanding Balance at Year End Principal Paid Interest Paid Yearly Payment
0 100,000  
1 83,620 16,380 10,000 26,380
2 65,603 18,018 8,362 26,380
3 45,783 19,819 6,560 26,380
4 23,982 21,801 4,578 26,380
5 0 23,982 2,398 26,380
5 Year Total   100,000 31,899 131,899

  

Over the life of the reducing interest rate loan, only AED 131,899 would be paid back as compared to the AED 150,000 that was paid back using the flat interest rate. The reason for this is that the interest payments are calculated based on the Outstanding Balance at the beginning of each year (which decreases as you pay back the principal).  With a flat rate, the interest paid is not calculated based on the Outstanding Balance at the beginning of each year, rather, it is calculated based on the original loan amount. 

The question now becomes which rate is better for a loan? If a bank advertises a 4% flat rate while another bank advertises a 6% reducing rate, the reducing rate is actually cheaper!  bayzat now allows you to compare interest rates for auto loans, personal loans and home loans either as flat or reducing rates so that you can compare apples to apples. 

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