What it means
Lenders quote interest in two main ways. A reducing balance rate charges interest only on the amount still owed, which falls as the borrower repays.
A flat rate charges interest on the original amount for the whole term, even though the balance is shrinking. Because a flat rate ignores repayments, a flat rate of 5% is far more expensive than a reducing balance rate of 5%.
The equivalent flat rate bridges the two by expressing the total interest of a reducing balance loan as a flat percentage. It lets someone check whether a quote from one lender is really cheaper than another's.
To use it, you take the total interest paid across the whole loan, divide by the original amount borrowed, and divide again by the number of years. The answer is the flat rate that would produce the same interest bill.
It is easy to calculate, which is why it appears in consumer loan advertising in some markets. The trouble is that it hides how much the true cost of borrowing is.
Since borrowers repay gradually, the effective interest rate on the money they actually hold is much higher than the flat figure suggests. For a proper comparison, the annual percentage rate (APR), which accounts for the timing of repayments, is a better measure.
Equivalent flat rates are best used as a quick translation tool rather than a final decision tool. They are also affected by fees, so check whether those are included.
Always ask a lender to show the total amount repayable. The reverse conversion is also possible.
A lender that quotes a flat rate can be asked what reducing balance rate that corresponds to, which is usually much higher. Doing the sums both ways gives a clearer picture of what is on offer.
In practice
Real-world examples.
Example
A car dealer advertises finance at a "5% flat rate" on a $20,000 car loan over 4 years. The buyer works out the total interest as $20,000 x 5% x 4 = $4,000. She compares this with a bank offering a lower reducing balance rate and picks the cheaper total.
Example
A small business owner is offered two equipment loans, one quoted as a flat rate and one as a reducing balance rate. He converts both into total interest dollars and then into equivalent flat rates. The comparison shows the reducing balance loan is cheaper.
Example
A financial adviser teaches clients to ask, "What is the total amount I will repay?" before signing. She uses the equivalent flat rate to show how a small flat rate can hide a high effective cost. She shows the same loan under both methods side by side. Clients then choose loans with more transparent pricing, and several negotiate lower fees as a result.
Formula
Calculation
Equivalent flat rate = Total interest / (Original loan amount x Term in years)
Worked example: A borrower takes a $10,000 loan over 2 years. The total repayments are $11,000, so the total interest is $1,000.
Equivalent flat rate = $1,000 / ($10,000 x 2) = $1,000 / $20,000 = 5%
The loan costs the same as a 5% flat rate. Because the balance falls over the two years, the equivalent reducing balance rate would be about 9%.Case study
Seen in the real world.
Greenfield Bikes is an illustrative, fictional shop that needed a $30,000 van loan. One lender offered a 6% flat rate over 3 years, and another offered a reducing balance rate that the owner could not easily compare.
The owner asked the second lender for a full repayment schedule. The total interest came to $4,200, so the equivalent flat rate was $4,200 / ($30,000 x 3) = 4.67%. The first lender's total interest at 6% flat was $30,000 x 6% x 3 = $5,400.
In this illustrative story, the owner chose the second lender and saved $1,200 in interest. The equivalent flat rate made the comparison simple, although she also checked the fees and the APR before signing.
Watch out
Common mistakes.
- Assuming a flat rate and a reducing balance rate of the same number cost the same, when the flat rate is much more expensive.
- Using the equivalent flat rate as the only comparison tool, when the APR gives a truer picture of cost.
- Forgetting to include fees in the total interest, when arrangement and administration charges can raise the real cost.
Questions
People also ask.
Why is a flat rate more expensive than a reducing balance rate?
Interest is charged on the original amount for the whole term, even though the borrower is steadily paying the balance down.
Is the equivalent flat rate the same as the APR?
No, the APR accounts for the timing of payments and usually fees, while the flat equivalent is a simple average over the original amount.
When is the equivalent flat rate useful?
It is useful for quick comparisons between loans quoted in different ways, or when the lender provides only total interest.
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