If you had to choose between a personal loan advertised at a rate of 18 percent or a loan at 24 percent, which one would you pick?

Naturally, most of us concerned about our rates would pick the lowest, as this would appear to be the cheapest. Not necessarily! Not until you understand whether the rate was calculated on a flat rate or reducing balance rate basis.

But what’s the difference?

Flat rates are usually lower than the reducing balance rate – a flat rate simply calculates the interest on the entire loan amount, without considering the amount already paid off. On the other hand, a reducing balance rate calculates the interest on the outstanding balance of your loan, which obviously reduces as you pay off your loan.

So before you pick the ‘lowest’ rate, make sure you have clarified the method of calculation of the rate advertized by your bank, and that you are comparing apples to apples.

Here is an example below – two loans being advertized, one at 18 percent and the other at 24 percent… Surely you should pick the 18 percent loan? See the calculations, if the loan at 18 percent was flat rate and the 24 percent loan a reducing balance rate…

Figure 1: Loan advertised at a flat rate of 18 percent

Year  Balance Principal paid Interest paid Total yearly repayment
0  100,000
1  80,000  20,000  18,000  38,000
2  60,000  20,000  18,000  38,000
3  40,000  20,000  18,000  38,000
4  20,000  20,000  18,000  38,000
5  –  20,000  18,000  38,000
5-yr total    100,000  90,000  190,000

Figure 2: Loan advertised at a reducing balance rate of 24 percent

Year Balance Principal paid Interest paid Total yearly repayment
0  100,000  –  –  –
1  88,240  11,760  22,762  34,522
2  73,326  14,914  19,607  34,522
3  54,412  18,915  15,607  34,522
4  30,423  23,988  10,534  34,522
5  –  30,423  4,100  34,522
5-yr total    100,000  72,610  172,610

Now you can see that a loan at a flat rate of 18 percent is more expensive than a loan at a reducing rate of 24 percent – so make sure you check the fine print – flat rate or reducing balance – before choosing a product.

If you need to convert your reducing balance to a flat rate, one of the methods is to divide by 1.813. There are other tools online where you can type in your rate and convert.

You will find the concept of a flat rate or reducing balance coming up whatever finance you’re looking at – personal loans and finance, car loans and finance or home loans (mortgages) and finance).

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