Flat Rate Trap

A friend sent me a car loan offer this week, pretty pleased with it. Ten percent flat, he said. Lower than the bank's rate, so he was about to sign.

I asked him to ignore the rate for a second and send me two numbers instead. The EMI and the number of months.

Here is what the word flat does. On a normal loan, interest is charged on what you still owe. Pay some back, you owe less, you are charged less. A flat rate ignores that. It charges interest on the entire original loan every year of the tenure. Even in the final year, when you have handed back almost all the principal, you are still paying as if the full amount were outstanding.

Run his numbers. Six lakh, five years, ten percent flat. That is 300000 in interest and an EMI of 15000. Now price the same six lakh at a genuine ten percent reducing balance. The interest is about 165000 and the EMI is 12748.

Same loan. Same advertised rate. The flat version costs 135000 more, and the true rate you are paying works out to roughly 17.3 percent, not ten.

A quick tell for anyone comparing offers. A flat rate runs close to 1.8 times its real reducing balance cost. So a flat 10 is really a 17 to 18. If a lender quotes flat and a bank quotes reducing, you are not comparing two rates, you are comparing two languages.

The fix is one question. What is the EMI and for how many months. Multiply the two, subtract the loan, and you have the real interest no sticker can hide.

The rate on the poster is marketing. The EMI is the contract. Read the one that actually moves your money.

How lenders quote a rate to make it look smaller: