BackDYK | Flat rate and effective rate on personal loans differ
Check the effective rate of interest on the loan. Flat rate will always be lower
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While requesting a bank to book a fixed deposit or enhance credit card limit, it is not unusual that after the bank executive gives you the required details, she follows it up with information such as: “We are offering you a personal loan at 6.99% flat rate." You may think this cheap, but it may not be so. Here’s why.
Flat rate and effective rate
Any loan has two components: principal and interest. Principal is the amount borrowed from a financial institution, and interest is the money paid back over and above the principal amount. Generally, loans are structured in such a way that during the initial repayment period, the borrower pays more towards interest and less towards principal. The equated monthly instalment (EMI) paid over a period of time gradually reduces the principal amount.
A flat interest rate does not factor in the gradual reduction in the principal amount. For instance, if your bank is offering you a flat interest rate of 7%, and you borrow 5 lakh for a period of five years, the total EMI will be approximately 11,380. In this case, the effective interest rate will be approximately 13% per annum. Though you will be paying 11,380 as EMI, the way the bank presents the interest rate figure is misleading.
Always remember to check the effective rate of interest on the loan. Flat rate will always be lower than the effective interest rate and it does not reflect the actual cost of the loan.
What should you do?
While availing a loan, always check the interest rate carefully. If you are being offered a rate below the base rate, it is a red flag. Remember that no bank can lend money below the base rate. Better still, while opting for loans, check if the mentioned rate of interest is the effective rate. This is because financial institutions try to sell a higher interest rate-product using the garb of flat interest rate.
In case of a personal loan, besides the interest rate. look at other charges such as processing fees and prepayment charges. Processing charges are in the range of 0-0.25% of the loan amount whereas prepayment charges can go up to 5% of the outstanding loan amount.
At present, the effective rate of interest for personal loan is in the range of 12.99-32% per annum. To find the effective rate on your loan, you could use an online calculator as well.
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