Making you opt for loans during your financial needs is like music to the ears of bankers. The lenders generally offer different types of loans in order to meet your financial needs to fulfill your desires. As an individual, many decide to avail small size loans like home loan, vehicle loan, personal loan, education loan and loan against property and gold loan. All of these loans have different format of interest rates and tenures. There are many occasions, when the bank employees or agents who deal with you while applying for loans, sometimes present a glossy image to make loans more appealing to you. There have been instances, where you are not even aware of the detailed terms and conditions, hence, are trapped in making monthly repayment. One such term which often many are not aware are called flat interest rate.
Flat interest rates are calculated on your full amount of the loan throughout the tenure. This means, they don’t even consider the monthly EMIs which gradually reduces the principal amount. Noticeably, the Effective Interest Rate is quite higher compared to that of nominal Flat Rate quoted in the beginning.
To your horror, you realise that lenders have trapped you by showcasing the flat interest rate on your loan and not the effective interest rate on the amount your EMIs are actually calculated.
Aditya Kumar, Founder & CEO Qbera.com, “Many Lenders in the present day often prefer to advertise the Flat Rate of Interest, as publicizing the Effective Interest Rate (or the real interest rate per say) doesn’t quite qualify as an appealing marketing stunt, simply because the EIR is way higher than its corresponding Flat Rate.”
Kumar added, “You’d have often found certain P2P lenders offering personal loans at ridiculously low rates of interest, sometimes in the range as low as between 8% and 12%.”
Further Kumar explains, this is, however, the Flat Interest Rate, and the real cost of borrowing is far from being reflected by this rate. In other words, Flat Interest Rates on a loan aren’t Flat – in fact, they don’t apply to your repayments at all. It is the Effective Interest Rate (also known as the Reducing Balance Rate) that reflects the real cost of borrowing and subsequent repayments.
The difference between flat and effective interest rate is that, the rates under former is calculated on the entire loan principal over the course of the loan tenure.
Whereas the latter, on other hand, is calculated on the outstanding balance, after taking into account your monthly repayment amounts. This means that the interest is constantly levied on the outstanding balance after considering consistent month-on-month repayments, until the loan amount closed in full.
Not only this, there is also the Reducing Balance Rate regime, which is often higher than the Flat Interest Rate by an incidence of at least 6-8%, or more.
Kumar thus says, “So next time you see a lender promising you the lowest rates in the market, look again – it might be the Flat Interest Rate for all you know. ”
Explaining about how you are trapped in personal loan when it comes to flat interest rate Gaurav Gupta, Co-founder and CEO, MyLoanCare.in explains saying, “A personal loan at a flat rate of 9% may sound like a bargain deal for any borrower, especially when compared to minimum reducing rates of 11-11.5% personal loan. But, there is a catch. The first quote is a flat rate which is highly deceptive and is not comparable with reducing loan rate which is the real or effective cost of a loan.”
So, in this example, the effective reducing rate on a two year personal loan at flat rate of 9% translates into 16.5% reducing loan rate. As a result, even a lower flat rate results in a significantly higher interest outgo.
According to MyLoanCare, flat rate loan schemes were very popular in micro finance sector during the initial growth years, but later withdrawn as they faced a flak from the regulator for misguiding a borrower into taking an expensive loan.
However, Gupta says, “the practice still continues in other segments like personal loans or consumer durable loans where some lenders are quoting flat rates to make their expensive loans marketable. It is important for a borrower to understand the effective or reducing rate on such loans to be able to make like to like comparison and take an informed decision.”
In Anuj Kacker, co-founder and COO, MoneyTap views, what many loan applicants don’t realize is, a loan at flat interest rate has the potential to be more expensive over time because it’s charged on the original principal amount throughout the tenure.
“Many people go for a lower flat rate interest assuming they’ll save money, but in the long run, they end up paying more interest compared to reducing balance rate,” says Kacker.
According to MoneyTap here’s how you are fooled with flat interest rate with an example. Let’s suppose if someone takes a loan of Rs. 1 Lakh @ 10% flat rate interest for 36 months, they’ll pay Rs. 30,000 as interest. Whereas the same loan @ 15% reducing balance rate, will incur only Rs 24,795 as interest.