Difference between Flat Rate and Effective Interest Rate

interest rate pic cartoon

Image credit : Inkcinct Cartoons

 

What is Flat Interest Rate?

A Flat Interest Rate plan computes interest payments based on the initial original principal. It is commonly applied to car loan financing in Singapore.

For example: A borrower takes up a loan of $100,000 over 5 years @ 3% flat interest rate. The total interest that the borrower pays at the end of the 5 years tenure is $15,000 ($100,000 * 3% * 5 years). The monthly interest repayment is $250/month ($15,000/60months) regardless of subsequent principal reductions.

 

What is Effective Interest Rate?

An Effective Interest Rate plan computes interest payments based on the remaining outstanding principal at the end of each term and works on computing interest on a reducing balance basis. It is commonly applied to mortgage loan financing in Singapore.

For example: A borrower takes up a loan of $100,000 over 5 years @ 3% effective interest rate. The total interest that the borrower pays at the end of the 5 years tenure is $7812.14. The interest computation is done based on the outstanding principal balance at the end of each repayment month.

 

Flat Interest Rate vs Effective Interest Rate?

From the above illustration example, we can see that Flat Interest Rate is about 1.92 times more than an Effective Interest Rate term. Depending on the loan tenure, as a general rule of thumb, Flat Interest rate terms are almost always about 2 times of Effective Interest Rates.

For smart interest comparisons, always make references based on Effective Interest Rates.

 

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