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. So, when a bank offered to convert the credit card outstanding of my friend into a personal loan at 18% flat rate of interest for 1 year, he jumped at the proposal and immediately agreed. He thought that 18% interest is better than 30% interest that the bank usually charges on credit card outstandings. So, was he wrong? Yes, read below to find out.
Usually banks quote between 16-24% interest rates on reducing balance. For flat rate of interest, they usually quote 13-15% (which obviously looks cheaper if you just see the numbers in isolation). However, if you apply a bit of simple mathematics, you will realize that your flat rate loan costs you much more than the one on reducing balance, even though the rate of interest on flat rate loan is lesser.
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).
In a reducing balance scheme, the interest goes on reducing according to the reduction in Principal. Even though all the EMIs are same, you pay less principal and more interest at the beginning, and as your loan nears the end of its term, you pay more principal and less interest.
An important concept is ’’Effective rate of interest’’. The effective rate of interest for flat rate loan is much higher as compared to that on reducing rate of interest. If you ever want to find out what is the effective rate of interest on your loan, just do a google search and you will get hundreds of sites where you can calculate how much interest you are actually paying. By the way, the 15% flat rate of interest loan for 1 year (with equal monthly installments) will have an effective rate of interest of around 26%.
To see some scenarios like that, you can visit this site - https://.iinvestor.com/scripts/calci/asp/calcConv.asp
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