Flat rate vs reducing balance
Two loans with the same quoted rate can cost very different amounts. The difference is what the interest is charged on.
Reducing balance
Interest is charged only on what you still owe. Each payment is the same, but early payments are mostly interest and later ones are mostly principal. Banks in Kenya quote loans this way.
Flat rate
Interest is charged on the original amount for the whole term, even after you have repaid most of it. Some SACCOs, chamas and lenders use it because it is easy to work out.
Worked example: KSh 500,000 at 14% for 36 months
| Reducing balance: monthly payment | KSh 17,089 |
| Reducing balance: total interest | KSh 115,197 |
| Flat rate: monthly payment | KSh 19,722 |
| Flat rate: total interest | KSh 210,000 |
| Extra cost of flat rate | KSh 94,803 |
A 14% flat rate over 3 years costs about the same as a 24.4% reducing balance loan.
Frequently asked questions
How do I compare two loan offers? Put both into the calculator with their fees and compare the "Total you repay" line, not the quoted rate.
Should I pay a loan off early? With reducing balance, paying early saves interest. Check your contract for early repayment penalties first.
What about saving instead? If you can wait, a money market fund or a T-bill lets your money earn interest instead of paying it.
For education only, not financial advice. Your lender's figures may differ slightly because of rounding, payment dates and fees.