Flat-rate vs reducing-balance loans: what is the difference?

When you borrow money, the interest rate is only part of the story. How the interest is calculated matters just as much. Two common methods are flat rate and reducing balance, and they can produce very different costs.

Flat rate

With a flat rate, interest is calculated on the original amount you borrowed for the whole period, even as you repay part of it.

Example: You borrow ₦50,000 for 2 months at a flat 5% per month.

• Interest per month: 5% of ₦50,000 = ₦2,500.
• Interest for 2 months: ₦5,000.
• Total to repay: ₦55,000.

You know the exact total at the start, which is simple and predictable.

Reducing balance

With a reducing balance, interest is charged only on the amount you still owe. As you repay, the balance falls and so does the interest.

Example: You borrow ₦50,000 for 2 months at 5% per month on the reducing balance, repaying half the principal each month.

• Month 1 interest: 5% of ₦50,000 = ₦2,500. You repay ₦25,000 of the principal.
• Month 2 interest: 5% of ₦25,000 = ₦1,250.
• Total interest: ₦3,750.

The total cost is lower than in the flat-rate example, because the interest follows the shrinking balance.

Why the comparison matters

If you repay everything in one lump sum at the end, the two methods give the same result. The difference appears when you repay in instalments. A flat rate can then cost more than it first appears.

How to compare offers

1. Ask for the total amount to repay in naira, not just the percentage.
2. Ask how the interest is calculated and whether there are extra fees.
3. Check the repayment schedule and what happens if you pay early.
4. Compare the total cost across offers for the same amount and period.

Hidden costs to ask about

Processing fees, insurance, late payment penalties and charges for early repayment can all raise the cost. A trustworthy lender lists them clearly before you accept.

Borrow only what you can repay

Even a cheap loan becomes a problem if you cannot repay on time. Work out your repayment from your regular income before you apply, and keep a buffer.

Knowing how interest works turns you from a passive borrower into an informed one.

Written by the EarnNaija team at EarnNaija Digital Technologies. Tips are general guidance, not financial or legal advice.

This article is general information, not financial or legal advice. Earnings are never guaranteed. See our fees page for the exact costs.