Personal Finance Term
Flat Rate vs Reducing Balance
Two ways of calculating loan interest. A flat rate charges interest on the full original amount for the whole term, while a reducing-balance rate charges interest only on what you still owe, which falls as you repay. A flat rate always costs more than the same-numbered reducing-balance rate.
With a flat-rate loan, common in Malaysian car loans and some personal financing, interest is worked out on the original principal across the entire tenure, so you keep paying interest on money you have already repaid. With reducing-balance (used by home loans and many personal loans), interest is recalculated on the shrinking outstanding amount, so the interest portion of each payment drops over time. This means a 4 percent flat rate is far more expensive than a 4 percent reducing-balance rate, despite the same number.
The practical lesson is to never compare a flat rate directly against a reducing-balance rate as if they were equal. To compare loans fairly, convert to an effective or annual percentage rate, where a flat rate often roughly doubles once expressed as reducing balance. Understanding this difference protects you from financing that looks cheap on the brochure but is much costlier in reality, and it explains why early settlement on a flat-rate loan may save less than you expect.