Question

Give a reason why the flat rate is smaller than the effective rate of interest of flat-rate loan.

Answer 1

The banks and financial firms offer different types of loans to fulfill customer’s financial desires. Most of the banks and financial firms lend home loan, vehicle loan, personal loan, education loan and loan against property and gold loan.
It is really important to know how the bank will calculate interest on your home loan. There are two common methods which are used for calculating interest on loans :- flat interest rate method and reducing balance interest rates method.

Reducing/ Diminishing balance rate, as the term implies, means an interest rate that is calculated every month on the outstanding loan amount. In this method, the EMI includes interest payable for the outstanding loan amount for the month in addition to the principal repayment. After every EMI payment, the outstanding loan amount gets reduced. Therefore, the interest for the next month is calculated only on the outstanding loan amount.

Flat interest rate, as the term implies, means an interest rate that is calculated on the full amount of the loan throughout its tenure without considering that monthly EMIs gradually reduce the principal amount. As a result, the Effective Interest Rate is noticeably higher than the nominal Flat Rate quoted in the beginning. The formula of calculating fixed rate of interest is –

Interest Payable per Instalment = (Original Loan Amount * No. of Years * Interest Rate p.a.) / Number of Instalments

For example, if a borrower takes a loan of Rs 1, 00,000 with a flat rate of interest of 10% p.a. for 5 years, then the borrower would pay:

• Rs 20,000 (principal repayment @ 1, 00,000 / 5) + Rs 10,000 (interest @10% of 1, 00,000) = Rs 30,000 every year or Rs 2,500 per month.
• Over the entire period, the borrower would actually be paying Rs. 1, 50,000 (2,500 * 12* 5).
• Therefore, in this example, the monthly EMI of Rs. 2,500 which converts to a whopping Effective Interest Rate of 17.27% p.a.
  (Note :- the effective interest rate can be derived form the flat rate of interest with the help of any effective interest rate calculator available on the internet).

This method is particularly used to calculate the interest payable for personal loans and vehicle loans. In this method, you have to pay interest on the entire loan amount throughout the loan tenure. It is actually less popular among the borrowers because even if you gradually pay down the loan, the interest does not decrease. Flat interest rates generally range from 1.7 to 1.9 times more when converted into the Effective Interest Rate equivalent.

Benefits and drawbacks of flat interest rate

Benefits –

• Suitable for planning an accurate budget as the EMI remains constant throughout.
• Flat interest rates are lower than reducing interest rates.

Drawbacks-

• The Effective Rate of Interest paid by the borrower is considerably higher.
• The borrower cannot reap the benefit of a reduced rate even if he repays a considerable part of the principal.

Is the flat rate of interest suitable for the borrower?
Flat interest is not popular among the borrowers as the interest rate gets calculated for the whole term on the entire loan amount, even if the borrower repays the loan gradually and the principal amount goes down. When converted to Effective Rates of Interest, as seen above, flat interest rates are almost 1.5 to 2.5 times higher than a Reducing Rate of Interest.
However, which type of interest rate best suits the borrower is his/her personal preference. A flat rate would be better for someone who needs a stable rate of interest with no fluctuations or changes. It is imperative to assess flat and reducing interest rates and read all the fine print of a loan negotiation contract carefully before one opts for any one of them.
The best approach to compare the true cost of loan is to convert everything into the Effective Interest Rate equivalent.