Flat Rate of Interest vs Effective Rate of Interest

Flat rate of interest

Very often banks offer flat rate of interest to their consumers on products like credit cards and personal loans or other smaller loans. Flat rate of interest sounds good because the rates quoted by the banks are lower than the reducing balance interest rates and an average consumer understands the flat rate very easily.

The simplest explanation - when you take a flat rate loan, you are asked to pay interest on the whole amount (principal) during the whole tenure of the loan even when the principal is gradually reducing during the term of the loan. Suppose you take a loan of 1 lakh rupees at 15% flat rate of interest for 1 year. The EMI or equal monthly loan installment that you pay consists of both interest and a part of the principal. So, as you pay the EMIs, the principal goes on reducing. However, even as the principal is reducing, you are still paying the interest on the whole amount (1 lakh rupees).

Flat rate of interest is the interest charged on the full amount of a loan throughout its entire term and commonly known as a 'pre-determined' credit charge. The flat rate takes no account of the fact that periodic repayments, which include both interest and principal, gradually reduce the amount owed. Consequently the effective interest rate is considerably higher than the nominal flat rate initially quoted.

In the US, all lenders have to state the effective rate to borrowers; contracts based on flat rates of interest, already uncommon by the mid-1990s, were prohibited under the uniform credit Code legislation in the US.

Anyone confronted with a flat rate of interest should remember: a rough rule is that 9 per cent flat equates to about 17 per cent effective per annum, ie, double the flat rate less one per cent, although this varies with the term of the loan.


let me give u a snapshot of how the Flat rate works vis-à-vis the Effective Rate of Interest

Loan amount – 100000

Tenure – 12 months

Effective Interest Rate p.a. [Flat Rate p.a.] –

10.00% [5.50%]

12.00% [6.62%]

15.00% [8.31%]

20.00% [11.16%]

Now lets see what happens when the tenure changes

Loan amount – 100000

Tenure – 24 months

Effective Interest Rate p.a. [Flat Rate p.a.] –

10.00% [5.37%]

12.00% [6.49%]

15.00% [8.18%]

20.00% [11.07%]

So next time, when you are offered a Flat rate of Interest and it looks attractive, be wise, and recalculate. Its much more than what you can imagine.

A few links should be useful:

http://jaldiloanwala.com/Emi.asp
http://www.iimb.ernet.in/iimb/microfinance/Docs/Interest%20Calculation/InterestClassRoom.doc