Two loans can both be advertised at 12%, yet one can cost nearly twice as much in interest. The difference usually comes down to how the interest is calculated: on a flat rate or on a reducing balance. Once you know how to tell them apart, it's much harder for a low headline rate to mislead you.
The difference in one sentence each
- Reducing balance: interest is charged only on what you still owe, so it falls as you repay.
- Flat rate: interest is charged on the original loan amount for the whole term, even after you have repaid much of it.
The same 12% on Rs 1,000,000 for 5 years
| Reducing balance | Flat rate | |
|---|---|---|
| How interest is worked out | Each month, on the remaining balance | 1,000,000 × 12% × 5 years |
| Monthly payment | Rs 22,244 | Rs 26,667 |
| Total interest | Rs 334,667 | Rs 600,000 |
| Total repaid | Rs 1,334,667 | Rs 1,600,000 |
The flat loan costs Rs 265,333 more, even though both loans are described as "12%". In the last year of a flat loan, you are still paying interest as though you owed the full Rs 1,000,000, when you owe only a small part of it.
The formulas
Flat rate
Total interest = loan amount × annual rate × years. Monthly payment = (loan amount + total interest) ÷ number of months.
Reducing balance
EMI = P × r × (1 + r)ⁿ ÷ ((1 + r)ⁿ − 1), where P is the loan amount, r is the monthly rate and n is the number of payments. The Loan & EMI Calculator does this for you and shows the full schedule.
Converting a flat rate into its real equivalent
To compare offers fairly, you need to know what reducing-balance rate would give the same monthly payment. These are the equivalents on Rs 1,000,000:
| Flat rate | Term | Monthly payment (Rs) | Equivalent reducing rate |
|---|---|---|---|
| 8% | 3 years | 34,444 | About 14.6% |
| 10% | 3 years | 36,111 | About 17.9% |
| 12% | 3 years | 37,778 | About 21.2% |
| 10% | 5 years | 25,000 | About 17.3% |
| 12% | 5 years | 26,667 | About 20.3% |
| 15% | 5 years | 29,167 | About 24.7% |
The equivalent rate is often not far from double the flat rate. This is a rough guide for quick checks, not an exact rule.
Find it for your own loan
You can find the equivalent rate with the calculator by trial and error:
- Work out the payment you were quoted. Here, that's Rs 26,667 on Rs 1,000,000 over five years.
- Enter the loan amount and term in the calculator, along with a guessed rate.
- Raise or lower the rate until the EMI matches. At 18% it's Rs 25,393, at 21% it's Rs 27,053, and at about 20.3% it's Rs 26,667.
Instalment plans: the same idea in a shop
Instalment offers on phones, appliances and bikes rarely show a rate at all, but you can still work it out. Suppose a phone costs Rs 100,000 in cash, or Rs 20,000 down plus 12 payments of Rs 8,000:
- You are really borrowing Rs 80,000 (the price minus the down payment).
- You repay 12 × 8,000 = Rs 96,000, so the extra cost is Rs 16,000.
- That sounds like 20%, but because your balance falls every month, the reducing-balance equivalent is about 35% a year.
That doesn't automatically make it a bad deal, as it might be the only credit available to you, or you might need the item right away. But it does let you compare it fairly against saving up, or against another form of finance.
The lowest rate isn't always the cheapest
Fees can change which offer is best. Here are three offers for Rs 1,000,000 over three years, all on a reducing balance:
| Offer | Rate | Upfront fee (Rs) | Monthly EMI (Rs) | Interest (Rs) | Total cost (Rs) |
|---|---|---|---|---|---|
| A | 14% | 20,000 | 34,178 | 230,395 | 250,395 |
| B | 13.5% | 40,000 | 33,935 | 221,670 | 261,670 |
| C | 15% | 0 | 34,665 | 247,952 | 247,952 |
Offer B has the lowest rate and the lowest monthly payment, but it costs the most overall. Offer C has the highest rate, but it's the cheapest if you keep the loan for the full term. To compare accurately, add up every payment and fee. An annual percentage rate (APR) can help where a lender provides one, as it is meant to include some charges.
Floating rates: test the payment you could afford
Many bank loans in Pakistan use a floating rate, typically KIBOR (the Karachi Interbank Offered Rate) plus a margin. Your payment or term can change whenever the rate resets. Test this before you sign, by running your loan at a higher rate as well. For Rs 2,000,000 over five years, assuming each rate applies for the whole term:
| Rate | Monthly EMI (Rs) | Total interest (Rs) |
|---|---|---|
| 14% | 46,537 | 792,190 |
| 16% | 48,636 | 918,167 |
| 18% | 50,787 | 1,047,211 |
If the 18% payment would strain your budget, consider borrowing less or choosing a different term. Work out your take-home pay first with the Salary Calculator.
What about Islamic financing?
Islamic products such as murabaha and diminishing musharakah use a profit rate or rental structure, rather than interest. They are built differently from a conventional loan, so calculators give only a rough comparison. You can still compare the most important numbers: what you receive, every payment you make and any fees. Ask the provider for its full schedule, and speak to a qualified adviser if the Shariah structure matters to your decision.
Questions to ask before you sign
- Is this rate flat or reducing balance?
- Is it fixed for the whole term or floating? If it's floating, how often does it reset, and what is the benchmark and margin?
- What is the APR, if you calculate one?
- What are all the fees, including processing, insurance, documentation and legal costs?
- Are the fees paid upfront, or added to the loan?
- What is the total amount I will repay if I keep the loan for the full term?
- Is there a charge for paying early, and what is the penalty for a late payment?
- Can I have the full repayment schedule in writing?
Frequently asked questions
Is a flat rate or reducing balance better for the borrower?
At the same quoted percentage, a reducing balance costs less, because interest is charged only on what you still owe. To compare different percentages, convert them or compare total repayments.
How do I convert a flat rate to a reducing rate?
Work out the monthly payment on the flat rate. Then enter the same loan and term in a reducing-balance calculator, and adjust the rate until the EMI matches. On Rs 1,000,000 over five years, 12% flat is about 20.3% reducing.
Does paying early help on a flat-rate loan?
It depends on the lender's early settlement terms. Because interest on a flat loan is often fixed at the start, ask in writing how much you would save before you make extra payments.
This article is for education only and isn't financial advice. Rates and charges vary by lender, so check every figure with the lender before you commit.
This article is general information, not professional advice. See the disclaimer.