A flat interest rate or nominal interest rate is the rate that you see on any Bank’s advertisement. Normally on its financing products. For instance Personal Financing or Hire Purchase Financing. A flat interest rate is always a fixed percentage.
The Mechanism of Flat Interest Rate
Imagine you applied for a personal loan of:
- Financing amount of RM 100,000
- The flat interest rate of 5% per annum
- With 10 years tenure.
In simpler terms, if you borrowed RM 100,000 and have been paying it back, you still owe interest on the entire initial amount. Even if you’ve paid RM90,000, the 5% interest is calculated on the full RM 100,000. So, over 10 years, you’ll end up paying RM50,000 just for the interest (RM100,000 x 5% x 10 years) in addition to the amount you borrowed.
Advantages and Disadvantages of Flat Interest Rate
Advantages:
- The cost of financing is certain
- Monthly commitment does not change
Disadvantages:
- Higher cost of financing
- Rate does not following the market
Effective Rate
A floating rate is like a variable interest rate because it can go up and down while you’re repaying your loan. This type of rate is tied to the overall market or a specific index. So, if the interest rate goes up, people with floating-rate loans will have to pay more each month. On the flip side, if the rate goes down, their monthly payments will decrease.
The floating rate involves a benchmark rate like Base Rate, BR or Base Lending Rate, BLR [1], along with an additional rate determined by the bank [2]. This benchmark rate affects how much you’ll have to pay back for your loan throughout the repayment period.
The effective rate, which can also be called the interest rate margin or financing spread (generally fixed), is determined by several factors such as:
- The risk of lending money
- Additional costs for the bank (operating)
- Profit margin
This rate includes the possible expenses of giving out a loan and the risks linked to it. To make it clearer, let’s use an example to understand this concept better. Below is the mechanism of effective interest rate for your reference.
The Mechanism of Effective Interest Rate
Picture this scenario [3]. You requested a personal loan of RM 100,000 at an effective interest rate of 5% per year for a period of 10 years. With this type of interest rate, you’ll only pay interest on the remaining amount you owe after each instalment.
This means your interest payment will decrease each time you make a payment on your loan. By the end of the 10 years, you’ll only have paid RM27,300 in interest, which is almost half of what you would pay with a fixed interest rate!
Advantages and Disadvantages of Flat Interest Rate
Advantages:
- Lower cost of financing [4]
- Profit and cost benefit the Bank and consumer respectively
Disadvantages:
- Financing cost determine by the market
- Budget is hard to be done
- Additional cost to financing [5]
Source:
- Consumer Guide on The Revised Reference Rate Framework, BNM
- Introduction of Islamic Variable Rate Mechanism, BNM
- Flat to Effective Interest Rate Calculator, Loanstreet
- What is flat rate vs. effective interest rate & fixed rate vs. floating rate?, Direct Lending
- Effective Interest Rates VS Simple Interest Rates: Here’s What You Need To Know About The Loans You’re Paying For, Yahoo Finance