We all have come across advertisements offering consumer loans at flat simple interest rates. Have you ever doubted that the rates they are mentioning could be misleading? Because in the real world of finance, everything is compounding interest and never a simple interest.
The story of a simple flat-rate loan
Here is an example to understand the truth behind such a simple flat rate of interest.
Consider a 5-year loan of Rs. 1 lakh offered at a simple flat rate of 10%.
At 10% the annual interest on 1 lakh is 10,000. You have to pay the same interest for 5 years. This means you have to pay a total of 50,000 as interest in 5 years for a loan of 1 lakh. So, you pay back a total of 1,50,000 for the loan. And your EMI at a flat rate comes out to be 1,50,000 divided into 60 months (5 years), which is 2500 per month. Great.
Are you really paying an interest rate of 10%?
The reality is that you are not paying an interest of 10% but way more.
For a loan amount of 1,00,000 and a tenure of 60 months, if the EMI is 2,500 per month, the interest rate comes out to be 17.27% per annum compounded monthly or an effective interest rate of 18.71% per annum compounded annually.
So, next time when you see a simple flat rate of interest you now know that you need to consider the effective interest rate (p.a.c.a.) for the actual interest you are paying.