Leasing companies and finance offers often quote a flat interest rate. It looks cheap next to a bank loan's rate, but the two aren't measured the same way. Here's the difference, and how to compare them properly.
Flat rate: interest on the full amount, every year
With a flat rate, interest is charged on the original amount for the whole term, even though you repay part of it every month.
Total interest = amount × flat rate × years
Borrowing Rs. 5,000,000 for 5 years at 14% flat costs 5,000,000 × 0.14 × 5 = Rs. 3,500,000 in interest. The monthly installment is (5,000,000 + 3,500,000) ÷ 60 = Rs. 141,667.
Reducing rate: interest only on what you still owe
Bank loans and housing loans normally use a reducing (diminishing) balance rate. Each month's interest is worked out on the balance left, so as you repay, the interest part of each installment shrinks.
The same Rs. 5,000,000 over 5 years at 14% reducing costs about Rs. 116,341 a month and about Rs. 1,980,000 in interest, about Rs. 1.5 million less than the flat-rate deal.
Converting a flat rate to a real rate
The 14% flat lease above is the same as about 23% per year on a reducing basis, an effective annual rate of almost 26%. As a rough rule, for terms of 3 to 5 years the reducing rate is about 1.7 to 1.8 times the flat rate.
The leasing calculator does this conversion for any rate and period. Enter the flat-rate offer, then compare the “equivalent reducing rate” with what a bank would charge.
How to compare offers
- Ask whether the quoted rate is flat or reducing.
- Compare the monthly installment and the total amount you'll pay, not just the rate.
- Add other costs: insurance requirements, documentation fees and early settlement charges.
- A larger down payment lowers the amount financed, so it saves interest under both methods.
Comparing with a normal loan? Use the loan calculator, which uses the reducing method.