Difference between flat vs reducing rate of interest
‘Interest rate’ is a fairly common phrase in consumer finance. Whether you want to buy a new home or a sleek car, banks offer various attractive loan options in the UAE. But before you sign the official papers, one important thing to remember is the type of interest rate you choose. Two main interest rates apply to consumer loans in the UAE: flat rates and reducing rates. Let’s now look at the difference between flat vs reducing rates of interest so you can make informed decisions before taking out a bank loan in Dubai or other parts of the UAE.
UNDERSTANDING THE DIFFERENCES BETWEEN FLAT VS REDUCING RATE OF INTEREST
By understanding how different interest rates work, you can determine how much you would pay over the total duration of your personal loan in the UAE.
Here is what you need to understand about the two different types of interest rates and the rules that apply to loan payments.
WHAT IS FLAT INTEREST RATE FOR UAE BANK LOANS?
A flat rate is applied to a loan when the annual interest on the loan is set at the beginning of the period and remains the same throughout the payment cycle. This is accomplished by applying interest on the principal amount throughout the loan period.
For example, if your loan amount is AED 500,000 at 5%, your interest per year would be AED 25k for the entire loan period.
The following table is a typical example of how you would pay off the flat rate of interest on a loan.
Year | Balance of loan at start of the year | Flat rate interest at 5% | Payments | End of year balance |
|---|---|---|---|---|
Year 1 | Balance of loan at start of the year AED 500,000 | Flat rate interest at 5% AED 25,000 | Payments AED 100,000 | End of year balance AED 425,000 |
Year 2 | Balance of loan at start of the year AED 425,000 | Flat rate interest at 5% AED 25,000 | Payments AED 100,000 | End of year balance AED 350,000 |
Year 3 | Balance of loan at start of the year AED 350,000 | Flat rate interest at 5% AED 25,000 | Payments AED 100,000 | End of year balance AED 275,000 |
Year 4 | Balance of loan at start of the year AED 275,000 | Flat rate interest at 5% AED 25,000 | Payments AED 100,000 | End of year balance AED 200,000 |
Year 5 | Balance of loan at start of the year AED 200,000 | Flat rate interest at 5% AED 25,000 | Payments AED 100,000 | End of year balance AED 125,000 |
Year 6 | Balance of loan at start of the year AED 125,000 | Flat rate interest at 5% AED 25,000 | Payments AED 100,000 | End of year balance AED 50,000 |
Year 7 | Balance of loan at start of the year AED 50000 | Flat rate interest at 5% AED 25,000 | Payments AED 100,000 | End of year balance 0 |
With a flat interest rate of 5% across the payment cycle, the total interest paid would be AED 175,000.
REDUCING RATE OF INTEREST
On the other hand, if the loan is agreed based on a reducing rate of interest, the payment plan would be slightly different. The principal amount is reducing with each payment, which means that interest being paid also goes down gradually.
For example, if you take AED 500,000 as a loan at a 6% reducing rate, the interest on the first payment would be AED 30k. However, in the next instalment, the payment would be reducing to AED 25,800 since the interest is only applied to the unpaid principal balance of AED 430k. With each payment, the interest rate applies only to the remaining balance of the loan.
Year | Balance of loan at the start of year | Reducing interest rate at 6% | Payments | End of year balance |
|---|---|---|---|---|
Year 1 | Balance of loan at the start of year AED 500,000 | Reducing interest rate at 6% AED 30,000 | Payments AED 100,000 | End of year balance AED 430,000 |
Year 2 | Balance of loan at the start of year AED 430,000 | Reducing interest rate at 6% AED 25,800 | Payments AED 100,000 | End of year balance AED 355,800 |
Year 3 | Balance of loan at the start of year AED 355,800 | Reducing interest rate at 6% AED 21,348 | Payments AED 100,000 | End of year balance AED 277,148 |
Year 4 | Balance of loan at the start of year AED 277,148 | Reducing interest rate at 6% AED 16,628 | Payments AED 100,000 | End of year balance AED 193,776 |
Year 5 | Balance of loan at the start of year AED 193,776 | Reducing interest rate at 6% AED 11,626 | Payments AED 100,000 | End of year balance AED 105,402 |
Year 6 | Balance of loan at the start of year AED 105,402 | Reducing interest rate at 6% AED 6,324 | Payments AED 100,000 | End of year balance AED 11,726 |
Year 7 | Balance of loan at the start of year AED 11,726 | Reducing interest rate at 6% AED 704 | Payments AED 12430 | End of year balance 0 |
A reducing interest rate is also known as a diminishing interest rate. With a reducing interest rate of 6% across the payment cycle, the total interest paid would be AED 112,430.
So you could say that the main difference between flat vs reducing rate of interest is in the change in the interest rate. You can look at the tables above to understand how to calculate reducing interest rate to flat interest rate.
FREQUENTLY ASKED QUESTIONS
WHICH TYPE OF INTEREST RATE IS PREFERABLE?
There is no definitive answer to the ongoing debate of flat interest rate vs reducing interest rate. It entirely depends on the interest rate percentages being offered. In the example mentioned above, even with a higher rate (6%), a reducing interest rate would be preferable as the total amount being paid as interest for your UAE loan is lower (AED 112,430). However, if the flat interest rate is considerably lower than the reducing interest rate, this can be a more viable option.
Generally, if the interest rate is on the lower side, a flat rate of interest might be beneficial. Whereas, if the current interest rates are high, a reducing rate of interest could be the way to go.
IS THERE ANYTHING FURTHER THAT I NEED TO KNOW?
Like any other financial transaction, you must do your due diligence and evaluate all the necessary factors before finalising your loan provider. Sometimes having a lower interest rate may not be the best option if the exit terms and reputation of the financial institution are not favourable. Don’t forget to read the fine print and avoid being lured by low-interest rates.
You can always ask the bank staff for assistance and get complete clarity regardless of your interest type. The difference between a flat rate and a reducing rate of interest can be substantial. At times people confuse the two and end up paying more in the end. Seek answers from your loan officer if there are any queries before you make a final commitment.
For a head start, consider visiting any of the banks in Dubai.
Understanding the difference between flat vs reducing rate of interest will help you organise your finances better. For instance, when you are getting a car loan in Dubai, check the monthly payments and how the provider will calculate the interest rate. Similarly, while applying for a home mortgage in Dubai, opting for the type of interest rate that would fit your needs is extremely important, considering that this is a fairly long-term commitment.
You can also read our FAQs about mortgages to prepare yourself better.
