Flat rate vs reducing balance calculator

On a reducing-balance loan you repay principal every month, so the amount interest is charged on shrinks every month. By the final month you owe almost nothing and are charged interest on almost nothing. A flat rate ignores all of that: it multiplies the rate by the original amount and by the number of months, once, at the start. You keep paying interest on money you gave back months ago.

For a loan repaid in equal installments, the average balance outstanding over the term is a little over half the original amount. A flat rate charges as if it were the full amount the whole way through — so as a rule of thumb, a flat rate costs close to twice the equivalent reducing-balance rate.

Reversed, that gives you a quick sanity check when someone quotes a flat rate: roughly double it to get the reducing-balance rate you are actually being charged. A “1.5% a month flat” offer is closer to 3% a month in real terms. The effect gets worse as the term gets longer, and disappears entirely at a one-month term, where there is nothing repaid yet for the flat rate to overcharge on.

They are much easier to compute and to explain — you can work one out in your head, which matters when a loan is being agreed across a table rather than by a system. Plenty of informal lending uses flat rates for exactly that reason, with no intent to mislead.

• Say which kind it is. “2% a month on the reducing balance” and “2% a month flat” are different agreements, and the ambiguity is only ever discovered during an argument about the final payment.
• Show the total. Agreeing on “you will repay $12,400.00 in twelve payments of $1,033.33” leaves nothing to reinterpret later.
• Expect no reward for early repayment. On a flat plan the interest was fixed at the start, so paying early shortens the loan without saving anything. If you want to give the borrower a reason to pay early, use a reducing-balance plan.

Flat: add-on / flat rate, and bullet. Reducing balance: monthly amortization, diminishing balance, and fixed principal + interest. Interest-only sits apart — the rate is charged on the balance, but the balance never falls until the balloon, so it costs the same as a flat plan. All six compared.