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  • Jan 05, 2022

What Is The Difference Between A Flat Rate & A Reducing Rate Of Interest?

In the world of consumer finance, the term “interest rate” is quite frequent. Whether you want to buy a new house or a car, banks in the UAE provide a variety of appealing financing choices. As a matter of fact, most people, when they have to buy property in Dubai, look for home mortgage loan options.

However, before you sign the formal paperwork, you should consider the sort of interest rate you want to use. Interest on a mortgage can be computed in two ways: flat and reducing rates of interest.

A flat interest rate is the one in which the interest rate payable remains the same during the life of the loan since it is always computed against the original loan amount.

On the other hand, a reducing rate of interest is the one in which the amount of interest to be paid is calculated against the remaining loan amount rather than the original principal amount.

A flat rate of interest is sometimes offered as a lower, more enticing rate than its counterpart. 

How to Decide Between a Flat Rate and a Reducing Rate of Interest?

Primarily, you have to understand the working of different types of interest rates. After that, you can then calculate how much you’ll pay over the life of your personal loan in Dubai or in any other Emirates.

Where Flat Rate Interest is Used?

The flat rate method is particularly useful for calculating the amount of interest owed on personal and vehicle loans. You must pay interest on the entire loan amount during the tenor if you use this technique. 

It is actually less popular among borrowers because the interest does not reduce even if the loan is gradually paid down. When adjusted to the Effective Interest Rate equivalent, flat interest rates are typically 1.7 to 1.9 times higher.

Where Reducing Rate of Interest is Used?

The interest payable on houses, mortgages, property loans, and credit cards is calculated using the reducing rate approach. You just have to pay interest on the outstanding loan amount if you use this technique. 

The Effective Interest Rate, which is identical to the interest rates used for Fixed Deposits (FDs) and Savings Accounts, is quoted for such loans.

How does Interest work?

The first thing to grasp is the distinction between how interest is calculated and how interest rates are adjusted gradually. The first is a component of the interest calculation, while the second is the underlying mortgage product. You can also mix and match these two.

For instance, a ‘flat rate’ is an interest calculation, whereas a ‘fixed rate’ is a mortgage product. That means you can have a flat fixed rate. However do remember that not all fixed rates are flat, and vice versa.

Example of Flat Rate

The flat rate of interest method is the same as when you use a simple calculator to compute your EMI.

For example, suppose you get a loan of AED 200,000 over 5 years with a 5% interest rate. This implies that regardless of how much you pay down the loan, you must pay 5% interest every year.

So, the total interest to be paid is AED 50000. It is calculated as the loan amount (200,000 x 5%) which equals to AED 10000. And then multiply it by the number of years, (10000 x 5 = AED 50000). 

In this way, a total of AED 50000 will be paid as interest over the course of 5 years, no matter how much you lessen it.

Example of Reducing Rate of Interest

On the other hand, this type of interest works totally differently. Your outstanding balance falls by the amount of principal repayment with each EMI payment, and interest is computed on that amount only the following month. As a result, the interest amount will be decreased accordingly.

Suppose if we apply for a loan of AED 100,000 with a 5% lowering balance rate and a 5-year repayment period. And if you are paying AED 20,000 per year in interest, then the first year’s interest will be AED 5,000. 

That indicates our balance is AED 80000, (80000 * 5%) = AED 4000. The same computation will be repeated for the following years.

And so you will pay a total of AED 15000 over the course of five years instead of AED 25000 if it would have been a flat rate interest.

Major Differences to Look for in Flat Rate vs Reducing Rate

Now that you have a fundamental grasp of both flat rate and reducing rate of interests, you may go on to the next step. In our comparison of flat rate vs. reducing rate-based loans, let’s now focus on the key distinctions between these two categories. Here’s how it goes:

Calculation

Flat-rate loans are those in which the interest is determined based on the total loan amount approved by the lender. However, in the case of a reducing rate, the interest is calculated on the outstanding principal balance in the loan.

Effective

Reducing rate loans are more profitable since their effective interest rates are lower than those on flat-rate loans.

Complexity in Computation

In this comparison of flat rate vs. reducing rate of interest, the flat rate comes out on top. Why? Because the interest amount is basic and easy to calculate at a flat rate. 

However, the reducing rate has a complicated computation because the interest is calculated by subtracting the principal amount from the previous instalment from the total loan amount.

Which One’s Better in the UAE?

In the United Arab Emirates, the flat rate is usually lower than the reducing rate of interest. However, it is solely dependent on the percentages of interest rates being given.

Wrap Up

The continuous debate between a flat interest rate and the reducing interest rate has no definite answer. In short, there are advantages and disadvantages of both flat rate and reducing rate interests. 

Reducing rate-based loans is beneficial because you pay a smaller amount during repayment, but they are difficult to calculate. 

On the other hand, flat-rate loans are convenient because the monthly payment stays the same and the interest rate stays the same, but you’ll wind up spending more throughout the life of the loan.

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