Flat rate and reducing interest rates uncovered

Calculating interest vs. the mortgage product

The first thing to understand is the difference between the way the interest is worked out and how the interest rate is adjusted over time. The first is part of the interest calculation and the second is the underlying mortgage product – and it’s possible to mix and match the two.

For example, ‘flat rate’ is an interest calculation, and ‘fixed rate’ is a mortgage product – so you can have a flat fixed rate, but not all flat rates are fixed and not all fixed rates are flat! Confused? Let’s explain the terms:

Flat rate vs. reduced rate – the interest calculation

Flat rate

Flat rate is a simplified form of interest where the annual interest is set at the beginning of the loan based on the principle (or initial amount) of the loan.

For example, if you have a mortgage for 1,000,000 AED with a flat rate of 4% the interest is set at 40,000 AED per year. No matter what year of your mortgage you are paying, whether it is the first or the fifteenth, the interest for the year is 40,000 AED.

It’s the easiest way of understanding flat rates that makes it so agreeable to many borrowers.

However, it’s the subtle high rate of return that makes it so agreeable to many lenders.

Reduced rate

A reducing rate of interest (also called ‘diminishing rate’) is when the interest is recalculated at the beginning of each year based on the current mortgage balance. A reduced rate of 6% on a mortgage of 1,000,000 AED will seem higher in the first year, with 60,000 AED being generated in interest, but in fifteen years, if half the principle has been paid by that point, the interest will also be halved and only 30,000 AED will be added that year.

4% flat rate vs. 6% reduced rate – an example:

First a look at a flat rate at 4%. This over-simplified example shows an initial balance of 1,000,000 AED paid at 100,000 AED per year with a flat rate of interest of 40,000 AED applied annually.

 Year Balance of loan at start of year (AED) Flat rate interest at 4% Payments made (AED) Balance at end of year (AED) 1 1,000,000 40,000 100,000 940,000 2 940,000 40,000 100,000 880,000 3 880,000 40,000 100,000 820,000 … 10 460,000 40,000 100,000 400,000 11 400,000 40,000 100,000 340,000 12 340,000 40,000 100,000 280,000 … 16 100,000 40,000 100,000 40,000 17 40,000 40,000 80,000 0

After 17 years, the loan is cleared and a total of 1,680,000 AED has been paid. The interest totalled 680,000 AED = equal to 17 annual interest additions of 40,000 AED.

Next a look at a higher reduced rate of 6%. Despite being a larger interest rate at the beginning, as the interest is calculated based on balance at the start of the year rather than the principle, the annual interest amount lowers each year.

 Year Balance of loan at start of year (AED) Reduced rate interest at 6% Payments made (AED) Balance at end of year (AED) 1 1,000,000 60,000 100,000 960,000 2 960,000 57,600 100,000 917,600 3 917,600 55,056 100,000 872,656 4 872,656 52,359 100,000 825,015 5 825,015 49,501 100,000 774,516 6 774,516 46,471 100,000 720,987 7 720,987 43,259 100,000 664,246 8 664,246 40,395 100,000 604,641 9 604,641 36,819 100,000 541,460 10 541,460 33,028 100,000 474,488 11 474,488 29,009 100,000 403,497 12 403,497 24,750 100,000 328,247 13 328,247 20,235 100,000 248,482 14 248,482 15,449 100,000 163,931 15 163,931 10,376 100,000 74,307 16 74,307 4,998 79,305 0

After 16 years, the loan is cleared and a total of 1,579,305 AED has been paid. Despite being a higher rate of interest, the reduced nature of the interest calculation means only 579,305 was paid in interest and the loan paid off a full year earlier – a saving of 100,695 AED.

Which is better – flat or reduced rate?

Generally it is better to have a reduced rate, especially if the length of the loan is long as the reduction makes more impact the longer the term – something which is typically true of mortgages as opposed to other types of loan, such as unsecured personal loans.

Reducing rate is also far better if you plan to make additional payments on the mortgage, as these supplementary payments can substantially lower the interest calculated in later years.

A flat rate is only superior if the percentage rate offered is substantially lower than comparable reduced rate mortgages.

Fixed vs. variable – the mortgage product

Your mortgage will typically include a choice between fixed and variable rates. Though these are also terms relevant to the interest, they deal with the rate of interest itself, and not how that interest is applied.

A fixed rate mortgage will offer a number of years where the interest rate is set, and may be either flat fixed, or reduced fixed as described above.

A variable rate will describe a changing level of interest, tied to inflation. Variable rate deals tend to always be a reduced rate as calculating flat variable rates is of little benefit and often very confusing to the borrower.

For more information on fixed and variable rate mortgages, read here.

Flat rate isn’t fixed rate – not getting caught out with Mortgage Finder

It’s easy to confuse one for the other, especially as the terms are so close – but flat rate doesn’t mean fixed rate and it’s important when reading about your mortgage that you don’t fall into the easy trap of applying for a mortgage on a low flat rate believing you are getting a low reduced fixed rate!

For help and to answer your questions, come to Mortgage Finder and we’ll sort the flats from the fixed! Give us a call or fill in our simple contact form for expert professional advice.