What is the difference between flat interest rate and effective interest rate?

Say you borrow $1000 for one year at a flat rate of12%. Let's then say you will repay this loan plus interest in four quarterly payments.

A flat rate (or simple interest) calculation says that the total interest for the year is $120. Therefore, you must repay $250 principal reduction + $30 for the interest at each repayment. At each quarter, you are paying one quarter of the total interest due for the whole year. After the first payment, you still owe $750 of the principal and $90 for the remaining interest over the remaining nine months (3 more payments) of the loan. 

Just consider the calculation of a loan of $750 taken for three quarters (9 months) and the interest turns out to be $90 for this period. If you put this info into the Simple Interest formula, you will find the annual rate of interest for this loan is16% rather than the12% you may have expected. 

Look at what happens in mid-year with the "flat rate loan". You will have $500 to pay in the remaining two payments for six months and you still owe the remaining $60 interest. In effect, you are borrowing $500 for half a year and paying interest of $60 for this. Again use the simple interest formula and you will find you would effectively be paying an annualized interest rate of24% on this $500.

Effective interest rates take into account the fact that you are NOT borrowing the entire principal for the entire loan. Each repayment is decreasing the principal. A flat rate calculation presumes the whole principal is borrowed for the entire loan period.

Hope this helps a little.

 

Another way (and probably simpler) to explain effective interest is to consider each of the four individual payements. Payment1 - $30 interest is12% of the principal payment of $250. But this principal component has only been borrowed for3 months. Effectively, the annualised interest paid on this component is48% Payment2 - $30 interest is12% of the principal payment of $250. But this principal component has only been borrowed for6 months. Effectively, the annualised interest paid on this component is24% Payment3 - $30 interest is12% of the principal payment of $250. But this principal component has only been borrowed for9 months. Effectively, the annualised interest paid on this Payment4 - $30 interest is12% of this final principal payment of $250. This is the only principal component that has been borrowed for the whole12 months. Effectively, the entire loan has had an interest charge of about twice the flat interest rate for the whole year. This rate is called the effective rate and, in further maths, is found by (2n)/n+1) times the flat rate. In this example, it is about22.15%

Effective interest rates take into account the fact that you are NOT borrowing the entire principal for the entire loan. Each repayment is decreasing the principal. A flat rate calculation presumes the whole principal is borrowed for the entire loan period.

Say you borrow $1000 for one year and you will repay this loan plus interest in monthly payments, eatch payment $100.

the flat rate is20%

the effective rate is21.939%

flat rate interest - same interest rate is fixed through out the period for the total loan

effective interest rate - same interest rate is fixed through out the period for a loan which will be diminising

Flat Interest rate is a fixed rate which is offerred by most of the banks through competition, while effective interest rate is calcluated as follows:

1- Rate on Risk free securities +

2- Inflation rate +

3- Economic Risk

 

I agree with Muhammad Waqas.

The flat Interest rate/Simple Interest rate is what you see now, like3.5% for the5 to7 years loan.which mean3.5% flat interest rate on your principal loan through out the next5 to7 years.This is easily to calculate.

So, Effective interest rate is derived from the flat interest rate.It is the rate of interest for the period of period t to t+1 formula. 

Flat rate of interest Very often banks offer flat rate of interest to their consumers on products like credit cards and personal loans or other smaller loans. Flat rate of interest sounds good because the rates quoted by the banks are lower than the reducing balance interest rates and an average consumer understands the flat rate very easily. The simplest explanation - when you take a flat rate loan, you are asked to pay interest on the whole amount (principal) during the whole tenure of the loan even when the principal is gradually reducing during the term of the loan. Suppose you take a loan of1 lakh rupees at15% flat rate of interest for1 year. The EMI or equal monthly loan installment that you pay consists of both interest and a part of the principal. So, as you pay the EMIs, the principal goes on reducing. However, even as the principal is reducing, you are still paying the interest on the whole amount (1 lakh rupees). Flat rate of interest is the interest charged on the full amount of a loan throughout its entire term and commonly known as a ‘pre-determined’ credit charge. The flat rate takes no account of the fact that periodic repayments, which include both interest and principal, gradually reduce the amount owed. Consequently the effective interest rate is considerably higher than the nominal flat rate initially quoted. In the US, all lenders have to state the effective rate to borrowers; contracts based on flat rates of interest, already uncommon by the mid-1990s, were prohibited under the uniform credit Code legislation in the US. Anyone confronted with a flat rate of interest should remember: a rough rule is that9 per cent flat equates to about17 per cent effective per annum, ie, double the flat rate less one per cent, although this varies with the term of the loan. let me give u a snapshot of how the Flat rate works vis-à-vis the Effective Rate of Interest Loan amount –100000 Tenure –12 months Effective Interest Rate p.a. [Flat Rate p.a.] – 10.00% [5.50%] 12.00% [6.62%] 15.00% [8.31%] 20.00% [11.16%] Now lets see what happens when the tenure changes Loan amount –100000 Tenure –24 months Effective Interest Rate p.a. [Flat Rate p.a.] – 10.00% [5.37%] 12.00% [6.49%] 15.00% [8.18%] 20.00% [11.07%] So next time, when you are offered a Flat rate of Interest and it looks attractive, be wise, and recalculate. Its much more than what you can imagine.

Flat Interest formula

Interest  = PRINCIPLE X Interest rate X TIME 

time for the whole period

Effective Annual  I = (1+ I/M)^m

Reduce interest = Principle BalanceX interest rate X time

time for the period till balance change