The short answer
A reducing-balance rate is cheaper at the same quoted number, because interest is charged only on what you still owe. A flat rate charges interest on the full loan throughout. On ₹5 lakh over 5 years, 10% flat equals about 17.27% reducing and costs ₹1.13 L more interest than 10% reducing.
Two ways to charge interest
A reducing-balance rate charges interest each month only on the principal you still owe. As you repay, the interest falls. Home loans and most bank personal and car loans work this way.
A flat rate charges interest on the original loan amount for the whole tenure, even though you repay part of the principal with every EMI. Flat rates are still quoted for some consumer durable, two-wheeler, used car and small personal loans, usually because the number looks lower.
Flat interest = Loan amount × flat rate × years. EMI = (Loan amount + flat interest) ÷ months
Since you repay principal from the first month, by the middle of the loan you owe roughly half the original amount but are still paying interest on all of it. That is why a flat rate always costs more than the same number quoted on a reducing balance.
A worked example on a ₹5 lakh loan
Take a loan of ₹5 lakh for 5 years. One lender quotes 10% flat, another 10% on a reducing balance.
| Method | EMI | Total interest | Total repaid |
|---|---|---|---|
| 10% flat | ₹12,500 | ₹2,50,000 | ₹7,50,000 |
| 10% reducing | ₹10,624 | ₹1,37,411 | ₹6,37,411 |
The flat loan’s EMI of ₹12,500 is exactly what a reducing-balance loan would charge at 17.27%. That is the real cost of the 10% flat offer.
| By end of year | Interest paid at 10% flat | Interest paid at 10% reducing | Difference |
|---|---|---|---|
| Year 1 | ₹50,000 | ₹46,348 | ₹3,652 |
| Year 2 | ₹1,00,000 | ₹84,201 | ₹15,799 |
| Year 3 | ₹1,50,000 | ₹1,12,668 | ₹37,332 |
| Year 4 | ₹2,00,000 | ₹1,30,766 | ₹69,234 |
| Year 5 | ₹2,50,000 | ₹1,37,411 | ₹1,12,589 |
Flat rates and their reducing-rate equivalents
The gap is not a fixed number of percentage points: it widens as the flat rate rises. The table shows the reducing-balance rate that gives the same EMI.
| Flat rate | Reducing equivalent, 3 years | Reducing equivalent, 5 years |
|---|---|---|
| 7% | 12.83% | 12.50% |
| 9% | 16.24% | 15.71% |
| 11% | 19.57% | 18.80% |
| 13% | 22.81% | 21.79% |
- A 7% flat rate over 3 years costs the same as 12.83% on a reducing balance.
- Going the other way, a 12% reducing rate over 5 years equals only 6.69% flat. A 7% flat offer is therefore costlier than a 12% reducing one.
- Across this table, the true reducing rate is 1.7 to 1.8 times the flat number, depending on rate and tenure.
When a flat rate can still be acceptable
The flat method is never cheaper at the same quoted number. It can still be reasonable when:
- you have converted it and the reducing equivalent is lower than the other offers available to you;
- the loan is small and short, such as a few months of a consumer durable purchase, so the rupee difference is modest;
- the offer is a no-cost EMI where the interest is genuinely absorbed by the seller, though check for a processing fee.
In every other case, compare on the reducing rate. If two offers both quote a reducing rate, the lower rate with similar fees is the cheaper loan.
How to compare two loan offers
- Ask each lender whether the rate is flat or reducing, and get it in writing.
- Convert any flat rate to its reducing equivalent for your tenure.
- Add the processing fee and GST, and compare the APR in each Key Fact Statement.
- Check prepayment and foreclosure charges, and on a flat-rate loan ask how the foreclosure amount is worked out.
- Compare the EMI and total amount repayable on the same loan amount and tenure.
Frequently asked questions
How do I convert a flat rate to a reducing rate?
Work out the flat EMI as (loan + loan × flat rate × years) ÷ months, then find the reducing rate that gives the same EMI. A flat-to-reducing calculator does this for you.
Is a flat interest rate always worse?
At the same quoted number, yes. A flat rate can still be acceptable if its reducing equivalent is lower than the other offers you have.
Which loans use a flat interest rate?
Flat rates are mostly quoted on consumer durable loans, some two-wheeler and used car loans, and small personal loans from some lenders. Home loans use a reducing balance.
What is the APR on a loan?
The annual percentage rate is the yearly cost of the loan including interest and fees, calculated on a reducing basis. It appears in the Key Fact Statement your lender must give you.
Does prepaying a flat-rate loan save interest?
It can, but the saving depends on how the lender works out the foreclosure amount, which may differ from a reducing-balance loan. Ask for the exact foreclosure amount and any charges before you prepay.