Two loans can both say “10%” and still cost very different amounts. The difference is whether interest is calculated on a flat rate or on a reducing balance. If you compare offers without knowing which method is used, you can easily pick the more expensive one.
Flat rate: interest on the original amount
With a flat rate, interest is calculated on the full original loan amount for the whole term, even though you repay part of the principal every month.
Total interest = Principal × Flat rate × Years
Reducing balance: interest on what you still owe
With a reducing balance, interest each month is calculated only on the outstanding balance. As you repay principal, the interest portion of each instalment falls. Most bank term loans and EMIs use this method.
Monthly instalment (EMI) = P × r × (1 + r)n ÷ ((1 + r)n − 1), where r is the monthly rate and n is the number of months.
Worked example
Loan: 1,000,000 for 3 years (36 months) at 10%.
| Flat rate 10% | Reducing balance 10% | |
|---|---|---|
| Total interest | 300,000 | about 161,600 |
| Total repaid | 1,300,000 | about 1,161,600 |
| Monthly instalment | about 36,100 | about 32,270 |
| Approximate equivalent reducing rate | about 18% | 10% |
The flat-rate loan costs about 138,000 more. Expressed as a reducing-balance rate, a 10% flat rate over three years is roughly 18% a year. As a rule of thumb, a flat rate is close to 1.7–1.9 times the equivalent reducing rate for typical terms.
Why flat rates look cheaper
The quoted figure is lower because it ignores the fact that you are repaying principal throughout. You pay interest on money you have already returned. That’s why consumer and SME lenders sometimes advertise flat rates for vehicle, equipment or short-term business loans.
How to compare offers properly
- Ask which method is used. If it’s not stated, ask for a full repayment schedule.
- Compare the total amount repaid over the same term, including all fees.
- Ask for the annual percentage rate (APR) or effective rate, where lenders are required or willing to give one.
- Check prepayment terms. On a flat-rate loan, repaying early may not reduce the interest much, depending on the contract.
What lenders look at
Whichever method is used, the lender will check whether your cash flow can cover the instalment. A higher instalment reduces your DSCR and may reduce how much you can borrow. See how much can my business borrow and how loan EMI is calculated.
Try it yourself
Use the EMI calculator to see the reducing-balance instalment, and the loan comparison calculator to compare two offers side by side.
Converting a flat rate into its true (effective) rate
If an offer only quotes a flat rate, you can estimate the equivalent reducing-balance rate with a simple rule of thumb:
Effective rate ≈ Flat rate × 2n ÷ (n + 1)
where n is the number of instalments. For monthly loans over several years, the effective rate is close to double the flat rate.
| Flat rate | Tenor | Approximate effective rate |
|---|---|---|
| 8% | 1 year (12 instalments) | about 14.8% |
| 8% | 3 years (36 instalments) | about 15.6% |
| 8% | 5 years (60 instalments) | about 15.7% |
| 10% | 3 years (36 instalments) | about 19.5% |
The rule of thumb is an approximation. For an exact figure, enter the instalment, tenor and amount in our EMI calculator or the loan comparison calculator and compare the effective rates side by side.
Fees change the picture too
Interest is only part of the cost. Before comparing two offers, add up:
- Processing or arrangement fees, often a percentage of the loan
- Documentation, valuation and legal fees
- Insurance or Takaful that the lender requires
- Early repayment charges, which matter if you expect to repay early
A loan with a slightly higher rate but no fees can cost less over its life than a “cheaper” loan with heavy upfront charges.
What about Islamic financing?
Islamic facilities such as Murabaha are priced differently. The bank sells goods to you at a fixed price that includes its profit. You still repay in instalments, so the same question applies: what is the effective annual cost of the price you are paying? Ask the bank to show the profit rate on a reducing-balance basis so you can compare fairly. For how the main structures work, see our guide to Islamic banking modes of financing.
From the credit desk
What we look for when this comes up in a real credit file:
- A flat rate quote can look cheaper than it is. When we compare offers we convert every quote into an effective annual rate on the reducing balance.
- Ask for the full repayment schedule, not just the instalment. The schedule shows exactly how much of each payment is profit or interest.
- Check the early settlement terms. On a flat rate loan, settling early can save far less than you expect, because the interest is fixed at the start.
Worked example: PKR 1 million over 3 years at a 12% flat rate costs PKR 360,000 in interest. The equivalent reducing balance rate is roughly 21% a year.
Frequently asked questions
Is a flat rate ever better?
Only if its effective rate, after fees, is genuinely lower than the alternative. The flat rate itself always looks lower than the true cost, so always convert before comparing.
Why do lenders quote flat rates?
They are simple to calculate and the headline number looks attractive. They are common in vehicle, consumer and microfinance lending.
What should I ask a lender for?
Ask for the annual percentage rate (APR) or effective rate, the total amount repayable, and a full repayment schedule showing principal and interest for each instalment.
Sources and further reading
- State Bank of Pakistan: Laws and Regulations (Prudential Regulations)
- State Bank of Pakistan: KIBOR rates
Related guides
- How Is a Loan EMI Calculated? The Formula, a Worked Example and the Flat-Rate Trap
- Fixed vs Floating Interest Rates on Business Loans
- Murabaha, Ijara and Diminishing Musharaka: A Simple Comparison
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