Flat rate or reducing balance? What your interest rate really costs
A 24% flat rate and a 24% reducing rate sound the same. Over twelve months, one costs the borrower almost twice as much interest.
The FinanceMe.lk team. . 6 minute read.
Most small lenders in Sri Lanka quote a flat rate. It is easy to explain and easy to work out on paper. But the number on the poster is not what the loan costs the borrower, and borrowers, regulators and courts increasingly ask for the real figure.
How a flat rate works
With a flat rate, interest is charged on the full amount borrowed for the whole term, even though the borrower pays part of it back every month.
Take a loan of Rs. 100,000 for 12 months at 24% flat:
- Interest: 100,000 × 24% × 1 year = Rs. 24,000
- Total to repay: Rs. 124,000
- Monthly instalment: 124,000 ÷ 12 = Rs. 10,333.33
By month eleven the borrower owes only about Rs. 10,000 of principal, but is still paying interest as if they owed Rs. 100,000.
How reducing balance works
With a reducing balance, each month’s interest is charged only on what the borrower still owes. The instalment stays the same, but more of it goes to principal over time.
The same loan at 24% a year reducing (2% a month):
- Monthly instalment: Rs. 9,455.96
- Total interest: Rs. 13,471.52
That is Rs. 10,528 less interest than the flat loan, for a rate that sounds identical.
Side by side
| 24% flat | 24% reducing | |
|---|---|---|
| Monthly instalment | Rs. 10,333.33 | Rs. 9,455.96 |
| Total interest | Rs. 24,000.00 | Rs. 13,471.52 |
| Equivalent reducing rate | about 41.7% a year | 24% a year |
| Effective annual rate | about 50.7% | about 26.8% |
The effective annual rate
The effective annual rate (EAR) is the single number that lets you compare any two loans fairly, whatever the method, frequency or fees. It answers: if this loan were a reducing balance loan with interest compounded each period, what yearly rate would it be?
For weekly loans the gap gets wider. A Rs. 50,000 loan repaid at Rs. 2,900 a week for 20 weeks is a flat rate of about 41.6% a year, but its effective annual rate is over 100%.
Processing fees deducted at payout push the EAR up further, because the borrower receives less cash but repays the same instalments.
Which should you use?
Both methods are legal and both are common. What matters is that:
- Your officers quote the same rate the same way every time.
- The borrower can see what the loan really costs before signing.
- Your schedule and your books use exactly the same numbers.
Flat-rate products are simpler for daily and weekly collection, where instalments must be round numbers. Reducing balance is fairer for larger, longer loans and is what banks use.
How FinanceMe.lk handles it
Each loan product chooses flat or reducing balance. When you create a loan, FinanceMe.lk builds the schedule, shows the instalment and total interest, and displays the effective annual rate including fees next to the quoted rate, on screen and on the loan agreement. If you change the term or the fee, every figure updates before you save.