Flat interest rate

A flat interest rate is calculated on the original loan amount for the entire term, regardless of how much the borrower has already repaid. Total interest is fixed at the moment the loan is written and does not change as the balance falls.

It is also called add-on interest, straight-line interest or fixed-sum interest.

Total interest = principal × flat rate × term in years
Instalment     = (principal + total interest) ÷ number of instalments

The contrast is with reducing balance interest, where interest is recalculated each period on the principal still outstanding. Under flat pricing, a borrower in the final month pays interest as though they still held the full original amount.

Worked example

$8,000 at 15% flat over 24 monthly instalments.

Total interest = 8,000 × 0.15 × 2      = $2,400
Total repayable = 8,000 + 2,400        = $10,400
Instalment      = 10,400 ÷ 24          = $433.33

Interest per month  = 2,400 ÷ 24 = $100.00  (constant)
Principal per month = 8,000 ÷ 24 = $333.33  (constant)

• Month 1: $433.33 payment ($100.00 interest + $333.33 principal) — $333.33 principal repaid to date
• Month 2: $433.33 payment ($100.00 interest + $333.33 principal) — $666.67 principal repaid to date
• Month 12: $433.33 payment ($100.00 interest + $333.33 principal) — $4,000.00 principal repaid to date
• Month 23: $433.33 payment ($100.00 interest + $333.33 principal) — $7,666.67 principal repaid to date
• Month 24: $433.33 payment ($100.00 interest + $333.33 principal) — $8,000.00 principal repaid to date

The constant interest column is the diagnostic signature of flat pricing. In month 24 the borrower has already returned $7,667 of principal, yet still pays $100 of interest — the same as in month 1, when they held the full $8,000.

What it actually costs

Because the borrower does not have the money for the full term, the effective cost is far above the quoted rate.

Quoted flat rate       = 15% per annum
Actual APR             ≈ 26.6% per annum (nominal)
Effective annual rate  ≈ 30.1%

How the multiplier varies with term

• 6 months: $600 total interest | $1,433.33 instalment | ≈25.2% approx. APR (≈1.68× flat rate)
• 12 months: $1,200 total interest | $766.67 instalment | ≈26.4% approx. APR (≈1.76× flat rate)
• 24 months: $2,400 total interest | $433.33 instalment | ≈26.6% approx. APR (≈1.77× flat rate)
• 36 months: $3,600 total interest | $322.22 instalment | ≈26.0% approx. APR (≈1.73× flat rate)

All at 15% flat on $8,000.

A useful rule: a flat rate is roughly 1.7 to 1.8 times its reducing-balance equivalent for a fully amortising loan with monthly instalments.

A commonly quoted shortcut gives a higher figure:

Approximate equivalent = flat rate × 2n ÷ (n + 1)

For 24 instalments that yields 15% × 1.92 = 28.8%. The difference is methodological: the shortcut applies simple interest to the average outstanding balance, while APR is an internal rate of return that discounts each cash flow properly. The shortcut is a fair mental estimate; the APR is the figure to use for any decision or disclosure.

Why flat pricing persists

• Computational simplicity. Total interest and the instalment can be worked out with a pen. Before loan management systems were widespread, this mattered enormously, and it still does where lending happens on paper.
• Explainability. "Borrow 8,000, repay 433.33 a month for 24 months" is easy to communicate and verify.
• Revenue certainty. Total interest is known at inception and does not vary with repayment timing.
• Convention. Asset finance and hire purchase have used add-on pricing for decades.
• It makes rates look lower. A lender quoting 15% flat appears cheaper than one quoting 24% reducing, when the flat loan is in fact the more expensive of the two.

The last reason is why regulators have moved against flat quoting rather than against flat calculation. The arithmetic is not dishonest; the comparison it invites is.

Note: cost-plus structures in Islamic finance, such as murabaha, produce a fixed total repayment that superficially resembles flat pricing. They are conceptually distinct — a disclosed markup on a sale rather than interest on a loan — and should not be conflated.

The early settlement problem

This is the practical consequence that matters most.

Under reducing balance, interest accrues as time passes, so settling early simply stops it. Under flat pricing, all the interest was charged at inception. A borrower settling at month 12 of 24 has been charged for twelve months they will not use — unearned interest — and whether they get it back depends entirely on the lender's rebate method.

• Actuarial: The true unexpired interest — the fair calculation
• Rule of 78: Substantially less than expected at mid-term
• No rebate: Nothing; the full contracted interest remains due

With no rebate, early settlement has zero financial benefit. The borrower simply pays the same total sooner.

The Rule of 78

The Rule of 78 — or sum-of-digits — allocates interest disproportionately to the early months. For a 12-month loan, the digits 1 through 12 sum to 78, hence the name. Month 1 is allocated 12/78 of total interest, month 2 gets 11/78, and so on down to 1/78 in month 12.

The effect at mid-term:

Interest allocated to months 1–6 = (12+11+10+9+8+7) ÷ 78 = 57 ÷ 78 = 73%

A borrower settling exactly halfway through has elapsed 50% of the term but is treated as having incurred 73% of the interest. Only 27% is rebated.

The rule is restricted or prohibited in a growing number of jurisdictions for exactly this reason.

The ambiguous balance

On a reducing balance loan, "what do I owe?" has one answer: the principal outstanding.

On a flat loan it has several. Principal outstanding is unambiguous. But the settlement amount depends on the rebate policy, which many agreements do not state clearly. Borrowers commonly assume their balance is total repayable less payments made — a figure that includes unearned interest and is not what they owe.

This ambiguity is a leading source of settlement disputes, and it is entirely avoidable through disclosure.

Regulation

Common approaches:

• Mandatory APR disclosure alongside any flat rate quoted, so the comparison is fair
• Prohibition of flat-rate advertising without a reducing-balance or APR equivalent
• Mandatory rebate of unearned interest on early settlement
• Restriction or prohibition of the Rule of 78
• Prescribed settlement quote content, showing principal, unearned interest and the rebate applied

Specific rules vary by jurisdiction and product.

If you lend on flat rates

• Disclose the APR or reducing-balance equivalent in the offer and the schedule, not only the flat rate.
• Use the actuarial rebate method and state it in the agreement.
• Publish the settlement basis so a borrower can calculate what they owe at any date.
• Show principal outstanding separately from total repayable on statements.
• Model the migration. Where regulators are moving toward reducing-balance mandates, converting pricing ahead of the requirement is easier than converting a live book under deadline.
• Expect competitive pressure. As borrowers become APR-literate, a 15% flat quote loses to a transparent 20% reducing quote that is genuinely cheaper.