What are Flat Interest Rates?

flat interest rates

If you have ever applied for a bank loan, then you know that there are quite a number of different types available. All of them have their advantages, disadvantages, and application process. While the loans might fundamentally differ from one another, one thing is constant in all of them; they all have interest rates attached. Interest rates are the main reason banks offer loans in the first place; it is how they make their money.

Before you apply for a particular loan, it is important to know the particulars. What you need to know is that the loans officer you deal with will most probably only showcase the glossy side of taking up the loan. They won’t necessarily highlight just how much more you will have paid back once the loan term comes to an end.

Interest Rates

mortgage rates

Just as different banks offer different types of loans (home loans, car loans, business loans, personal loans, etc.), they also have different types of interest rates charged on those loans. For the most part, you will find that the bank charges you either a “Flat Interest Rate” or a “Reducing Interest Rate.” There is a huge difference between the two and whichever one you choose will have a considerable impact on how much you end up paying.

What is Flat Interest Rate?

You calculate a flat interest rate on the full amount of the original loan without taking into account that the principal loan, as well as the interest charged, reduces with time. If you go in for a loan of $1,200 today and get a flat interest rate, you will know exactly how much you will owe for the entire tenure of the loan. 

If that $1,200 loan had a flat interest rate of 5% attached to it for 12 months, you would then be required to pay:

  • $100 for the 12 months to repay the principal
  • The monthly flat interest rate of 5% of the $100 will come to $5
  • Therefore, your monthly repayments for the loan term period will be $105 for 12 months

At the end of it all, you will have paid the bank the $1,200 you owe them plus an additional $60 on account of the flat interest rate. This is all the information you get as soon as you apply for the loan.

What are the Advantages and Disadvantages of Flat Interest Rates?

The flat interest rate model has some distinct advantages and disadvantages. Let’s start with the advantages:

Advantages of Flat Interest Rates:

  • Flat interest rates are predictable: this is one of the most significant advantages when it comes to dealing with flat interest rates – they are predictable. Because the amount owed per month does not change throughout the pay period, unlike when dealing with a variable interest rate, you can plan your finances around that figure. Thankfully, this takes the guesswork out of any monthly expenditures you may have or incur as the borrower.
  • You know whether or not you can afford it: with a flat interest rate, you will know whether or not you can afford to pay back the monthly installments beforehand and that gives you an opportunity to take up the maximum amount available to you. In many cases, you find that business owners take loans that they can get as opposed to the full amount they need because they do not know whether or not they can afford to pay it back based on their current business situation.

With a fixed interest rate, you can simply come up with a total figure that you are comfortable paying per month and calculate backward to find the ideal loan amount before walking into the bank. If you find that the ideal loan amount isn’t the figure you need, then you can get a full picture of how much you will need to pay per month for the full value and work with that information to ensure that you have that money ready every month to repay your loan.

  • You get to know how much the loan will cost you in its lifetime: Using the example we gave above; the $1,200 loan will cost you $60 over the 12 months. Knowing beforehand how much the loan will cost you over its lifetime is important because it will allow you to determine whether or not the loan is worth it in the long run. If the money is meant to grow your business and the cost of the loan exceeds the revenue brought in within the same period, then the loan isn’t worth it.

You will also know how much tax benefits you will get by deducting the loan’s interest. This figure is much more difficult to pinpoint when using other interest calculation methods such as variable interest rates.  Of course, the other advantage is that flat interest rates are much simpler to understand and calculate. You will not feel as if there is something the lender is hiding in the fine print.

Disadvantages of Flat Interest Rates

student loan interest rates

While transparency is the biggest advantage a flat interest rate loan offers, there are still some disadvantages that come with this form of borrowing. The biggest disadvantage is that a business loan with a flat interest rate attached can end up being more expensive over time. Take for example the following two examples:

Loan A: Fixed Interest Rate

  • Loan amount: $1,000,000
  • Loan term: 10 years
  • Interest rate: 10% fixed rate
  • Monthly payment: $13,210.51
  • Total interest paid: $585,800.88

Loan B: Variable Interest Rate

  • Loan amount: $1,000,000
  • Loan term: 10 years
  • Interest rate: 7.5% variable rate
  • Monthly payment: $11,870.02
  • Total interest paid: $424,420.12

In this example, the second loan is much cheaper than the first one with a fixed interest rate. Now, bear in mind that this scenario assumes the variable interest rate remains low and does not fluctuate into a higher figure over the 10-year period (not very likely to happen). Should that be the case, then the second loan will be much cheaper.

The only problem with variable interest rates is that they fluctuate, and you never really know how much you may be liable to pay by the end of the loan term.

As a business owner who does not want any financial surprises in the future, taking a loan with a fixed interest rate is perhaps the best course of action for you.

Posted in Finance
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