Loans are an incredibly intricate part of the economy; without them, it would be difficult for many financial transactions to take place. As a result, many institutions offer loans on the condition that people pay back interest.
However, there are many different kinds of loan interest out there, with reducing balance and flat interest rates being the most common. Despite the commonality, there is still a great deal of confusion about the difference between the two.
What’s The Key Difference Between A Reducing Balance And Flat Interest Rate?
A reducing balance interest rate is a set interest rate that is only applied to the remaining balance of a loan. In other words, the more you pay down on loan, the less each subsequent interest payment will be since the amount still owed will continually go down.
By contrast, a flat interest rate is based on the entire loan amount. Each interest payment per pay period will remain exactly the same during the entirety of the loan’s repayment.
In the long run, reducing balance interest rates tend to cost less overall since the amount of interest that has to be paid will continually be reduced. However, they also tend to have higher interest rates than flat-rate loans, so it’s common for reducing balance loans to come with higher interest payments initially.
Why Would Someone Pick One Loan Over The Other?
Either one of these loans comes with its own benefits and drawbacks, so there are many reasons why one type of loan would be considered preferable based on personal needs.
As previously mentioned, reduced balance loans will usually end up costing someone less than a flat rate one, which makes it a popular option. Although it comes with a huge benefit, its various downsides can make it unappealing. It’s generally difficult to calculate, and the initial interest payments can be very high.
By contrast, flat interest payments will always be the same and therefore easily predictable. Interest payments will also be initially lower, so they are a great choice for people using loans to offset the effects of cash flow problems.
Which One Is Right for You?
There are a lot of individual variables that will determine which of these interest types will be a good fit for you.
Generally speaking, if you’re in a good financial position and have an excellent grasp of how finances work, then reducing balance loans would be best, whereas flat interest loans would be more suited for people with limited financial history.
According to Lantern by SoFi, auto refinance plans tend to benefit tremendously from a reducing balance interest plan, so if you’re interested in saving money on a car loan, that might be a good choice.
Ensuring Your Financial Health
Finances can be tricky, and interest on loans is no fun to deal with, but you can make your loan repayment a breeze with the right interest rate plan.