A financial need can sometimes push buyers to borrow loans that are easily available from banks and financial institutions. While this is good for the lender, it is not often positive for borrowers.

Lenders offer various types of loans to cater to the financial needs of individuals. Many borrowers take out various retail loans like a home loan, vehicle loan, personal loan, education loan, gold loan, etc, to meet their varying financial needs.

All these loans come with different interest rates and tenures. At times, bank employees or agents may present a very shiny image for making loans look more appealing to applicants. Very often, borrowers are not aware of the detailed terms and conditions of loans. This could lead them to get trapped in a monthly repayment cycle, beyond their budget. One such hidden factor that borrowers often tend to ignore is the flat interest rate that is charged on some loans.

While flat rate loans have their pros, as a borrower you need to be cautious, understand the terms and conditions involved before signing up for one.

What are Flat Rates on Loans?

Flat interest rate is calculated on the total loan amount throughout the entire loan tenure. It does not consider the monthly EMIs that reduce the principal amount gradually. Hence, the effective interest rate is significantly higher as compared to the nominal flat rate stated at the beginning of the loan. The formula for calculating a flat rate of interest is –

For instance, for a loan of Rs 1,00,000, at a flat rate of interest of 10% p.a. for the tenure of 5 years, the calculation will be as below:

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.

Throughout the tenure, one would end up paying Rs. 1,50,000 (2,500 * 12* 5). Hence, in this example, the monthly EMI of Rs. 2,500 can be translated into an Effective Interest Rate of 17.27% p.a.

This method is often used for calculating the interest payable on personal loans and vehicle loans. Under this method, a borrower has to pay interest on the total loan amount for the entire loan tenure. This makes it less popular as despite gradually paying down the loan, the interest will not decrease. Flat interest rates usually range between 1.7 to 1.9 times more after converting them to the effective interest rate.

Flat interest rates are charged on the full loan amount and are applicable throughout the loan tenure. These calculations ignore the monthly EMIs that reduce the principal amount. It is worth noticing that the effective interest rate is significantly higher as compared to the nominal flat rate mentioned at the time of enrolment.

Often, borrowers realise that the lenders have trapped them by portraying a flat interest rate on the loan and not highlighting the effective interest rate that will be charged on the amount that the EMIs are calculated on.

Lenders often advertise a flat rate of interest on loans instead of publicizing the effective interest rate (or the actual interest rate) since it will not appeal to the target audience. Consumers will notice that personal loans are offered by lenders at unbelievably low rates of interest and this should ring alarm bells to borrowers as there are sure to be certain hidden terms related to interest rates.

Why Should Borrowers Be Wary of Flat Rates?

Flat Interest Rates on a loan aren’t flat. These do not apply to the repayments in any way. Lenders consider the effective interest rate (or the reducing balance rate) while calculating repayments. Thus, while determining the actual cost of borrowing, borrowers must consider the effective interest rate.

Flat rate is calculated on the total loan principal through the loan tenure. On the other hand, the effective interest rate is calculated on the outstanding loan balance, after considering the monthly repayments made by the borrower. This indicates that the interest is often levied on the total outstanding balance post-month-on-month repayments, till the time the loan amount is entirely paid. Hence, lenders who promise the lowest interest rates in the market must be carefully studied and the terms and conditions should be thoroughly evaluated.

Flat rate loans had been popular in the microfinance sector during the early years; however, these were later withdrawn since they faced a lot of backlash from the regulator for misleading borrowers into sourcing expensive loans. Despite this, the practice of offering flat-rate loans continues in many segments such as personal loans, consumer durable loans, etc. Lenders continue to quote flat rates to sell expensive loans to borrowers. Every borrower should understand the effective rate or reducing the interest rate on loans to be able to compare and make the right decision.

Most often, applicants don't realize that a loan which comes with a flat interest rate could have the potential of being more expensive over the tenure. This is because the interest is charged on the total principal value throughout the loan tenure. People choose a lower flat rate interest in the assumption that they'll end up saving money. But, in the long run, they could pay more interest as compared to reducing balance rate.

Impact of Flat Rates on Borrowers

Flat interest rate loans are generally offered at very low rates. When a loan is offered at very attractive interest rates, it should raise suspicion in the minds of borrowers. This is because banks are not permitted to offer loans below the specified base rates. Borrowers should read the terms and conditions carefully in such cases.

Banks may use tricks of offering attractive interest rates to attract customers. A lot of times, bank officials may not give complete clarity to borrowers and keep facts away from them. This could be done to meet their loan targets. However, it is the borrower’s responsibility to understand the terms and conditions of any loan carefully before agreeing to them.

Conclusion

The type of interest rate that is best suited to you is dependent on your personal preference. A flat rate can be better for a borrower who wants a stable rate of interest without any possibility of fluctuations or changes through the loan term. It is important to consider flat and reducing interest rates and carefully go through all terms and conditions before agreeing for one.