Flat Rate (finance) - Flat Rate Calculations

Flat Rate Calculations

To use the example above, the borrower only has access to $1,200 at the very beginning of the loan. Since $100 in principal is being paid each month, the average amount the borrower has access to during the loan term is actually slightly more than half of $1,200. This means that the effective interest on such a loan, if recalculated using the declining balance method, is nearly double the flat rate. "A general rule known by financial managers is that when flat interest is used, the APR is almost twice as much as the quoted interest rate."

In the first 3 examples on the right the borrower will be quoted 1% a month. These are loans of $1,200 each, amortized with level payments over 4, 12 and 24 months. In the 4-month example, the borrower will make 4 equal payments of $300 in principal and 4 equal payments of $12 (1% of $1,200) in interest. This yields an annualized flat rate of 12%, and an annualized effective APR of 19.05%.

To keep the quoted interest rate as low as possible, microcredit institutions often recover some of their lending costs by charging one-time origination or administration fees before disbursing loans. Because these fees are deemed an inherent cost of borrowing, developed countries generally require lenders to include them in APR calculations. Even an origination fee as low as 4% of the total loan can have a large impact on the borrower's total costs. This is especially true for short-term loans, as the last 3 examples in the table show. Microcredit loans are usually for 12 months or less.

In order to recalculate a flat rate as an effective APR, it is necessary to model a comparable loan using a declining balance amortization schedule, resulting in the same total cost to the borrower (see table on the left). The loan is for $1,200 repayable in level monthly payments over 4 months. The total cost of this loan includes the principal plus $48.00 in interest. The effective APR is calculated by iteration from the amortization schedule, using the compound interest formula.

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