Flat Rate Loans

Flat rate lending is one of the most common types of loan practices in the world today. The main reason for its popularity is because of its ease of calculation. For instance, a loan of $2,000 may be set up with two years of fixed monthly payments plus interest and is paid by the borrower on the same date each month. Flat rate loans are one of the most common types of lending for people with lower incomes. Here is a look at some of the many pros and cons that come along with flat rate lending.

Example of a Flat Rate Loan

A simple example of a flat rate loan would be if someone borrowed $1,200 for one year. Payments would be 12 monthly principal payments of $100, plus interest, due on the first day of each month. Interest would equal 1% of the total borrowed ($12) a month, resulting in a total monthly payment of $112. The loan could also be structured to pay $12 a month (interest only) with the full principal due at the end. This type of loan is common with Small Businesses in 3rd world countries in the microfinance industry where loans are often less than $1000.

Pros of Flat Rate Loans

As far as pros go, flat rate loans are extremely easy to calculate and track over a long period of time. The interest rates associated with these types of loans require no compounding calculations or calculations to blend interest and principal into a level payment. Because of the simplicity of this type of loan, commitments are made extremely clear and transparent to the borrower and payment history can easily be tracked by both parties. These types of loans are often used in developing countries, as flat rate loans originated before currency was even invented. Because of this, loans may be repaid in monthly installments of things like eggs, chickens, or rice. For borrowers already accustomed with this system, flat rate cash loans can be easily understood. These types of loans also help people who have certain cash flow needs. Whether there is a farmer who needs cash to harvest their crops or a business who needs the extra funding for a new building, a flat rate loan will ensure that the same amount will need to be paid each month, lessening the worry of the borrower to make the payments.

Disadvantages of Flat Rate Loans

While there are benefits associated with flat rate lending, there are also many negatives. For instance, borrowers of these loans can’t reduce their interest charges by pre-paying their loan ahead of time. Also, since the loan is on a flat rate system, even if the borrower needs to only borrow the money for a day, they will have to repay the loan plus the entire year’s interest. Another problem with this type of loan is that a flat rate may give the impression that the rate is much lower than it actually is. In the above example, with the principal lumped at the end to the uneducated, it may appear that the interest rate is 1% but it is actually 12%. But when the principal is paid back monthly the situation is even worse. In that case, since the balance is declining every month, the average balance due is about half of the total amount borrowed so the actual annual percentage rate (APR) interest is about double, i.e. 24% per year.

It’s important to note that because of this hidden interest cost and the high actual interest rate charges, flat rate lending is somewhat controversial within the microfinance world. Because of this a federal law was passed in 1968 to preventing flat rate loans in the U.S. The Truth in Lending Act was created to “outlaw loans in which a flat rate is assessed against a principal sum regardless of how much financing a person uses in a given month.” This means that if you are given $10,000 worth of credit and only used $2,000 of credit within a given year, you cannot be charged fees against that $10,000 worth of credit. Instead, you will only be charged against the amount that you borrowed.

Because of these restrictions, flat rate lending is much more common is lesser developed countries, as some governments do not regulate these types of loans. Although, because payday loans charge a flat fee up front they are similar to flat rate loans but escape the restrictions by calling it a fee rather than interest.

Fixed Rate Loan vs. Flat Rate Loans

One area of confusion is between the terms fixed rate and flat rate loans since because they sound so similar. Fixed interest rates are opposed to variable interest rates where the rate changes over the term of the loan. For instance a variable mortgage might charge you 3% for the first three years and then adjust it to 4% for the next five years and then adjust it again depending on the current going rate. Where a fixed rate mortgage might lock in 3.5% for the full length of the loan. Fixed rate loans are less risky because you know how much you will be paying for the entire term of the loan. Variable rate loans offer you a discount up front in exchange for reducing the risk to the lender because he can adjust the rate if market rates go up. But both of these types of loans only charge interest on the outstanding balance where flat rate loans charge interest based on the total amount borrowed.

See Also:

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• What You Should Know When Getting a Mortgage