Flat rate (finance)

Last updated April 01, 2019

Flat interest rate mortgages and loans calculate interest based on the amount of money a borrower receives at the beginning of a loan. However, if repayment is scheduled to occur at regular intervals throughout the term, the average amount to which the borrower has access is lower and so the effective or true rate of interest is higher. Only if the principal is available in full throughout the loan term does the flat rate equate to the true rate. This is the case in the example to the right, where the loan contract is for 400,000 Cambodian riels over 4 months. Interest is set at 16,000 riels (4%) a month while principal is due in a single payment at the end.

The riel is the currency of Cambodia. There have been two distinct riel, the first issued between 1953 and May 1975. Between 1975 and 1980, the country had no monetary system. A second currency, also named "riel", has been issued since March 20, 1980. The symbol is encoded in Unicode at U+17DB៛KHMER CURRENCY SYMBOL RIEL (HTML ៛).

Flat rate calculations

Loans with interest quoted using a flat rate originated before currency was invented and continued to feature regularly up to and beyond the 20th century within developed countries. More recently, they have also come to be used in the informal economy of developing countries, frequently adopted by microcredit institutions. One reason for the popularity of flat rates is their ease of use. For example, a loan of $1,200 can be structured with 12 monthly repayments of $100, plus interest, due on the same dates, of 1% ($12) a month, resulting in a total monthly payment of $112. However, 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 to which the borrower has access during the loan term is approximately half, in fact just over $600. For this reason, as mentioned above, the true rate of interest is nearly double. "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."^[1]^[2]

Microcredit is the extension of very small loans (microloans) to impoverished borrowers who typically lack collateral, steady employment, or a verifiable credit history. It is designed to support entrepreneurship and alleviate poverty. Many recipients are illiterate, and therefore unable to complete paperwork required to get conventional loans. As of 2009 an estimated 74 million people held microloans that totaled US$38 billion. Grameen Bank reports that repayment success rates are between 95 and 98 percent.

In order to show the true rate underlying a flat rate, it is necessary to use the declining balance amortization schedule, dividing the total cost to the borrower by the average amount outstanding. In the first three examples on the right the borrower is 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 four equal payments of $300 in principal and 4 equal payments of $12 (1% of $1,200) in interest. The total cost of this loan is the principal plus $48.00 in interest, whilst the average amount outstanding was approximately $600. This yields an annualized flat rate of 12%, and an annualized effective or true rate of 19.05%. The true rate can also be calculated by iteration from the amortization schedule, using the compound interest formula.

An amortization schedule is a table detailing each periodic payment on an amortizing loan, as generated by an amortization calculator. Amortization refers to the process of paying off a debt over time through regular payments. A portion of each payment is for interest while the remaining amount is applied towards the principal balance. The percentage of interest versus principal in each payment is determined in an amortization schedule. The schedule differentiates the portion of payment that belongs to interest expense from the portion used to close the gap of a discount or premium from the principal after each payment.

Compound interest is the addition of interest to the principal sum of a loan or deposit, or in other words, interest on interest. It is the result of reinvesting interest, rather than paying it out, so that interest in the next period is then earned on the principal sum plus previously accumulated interest. Compound interest is standard in finance and economics.

To keep quoted interest rates as low as possible, institutions also often call for one-time origination or administration fees. However, 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, a typical characteristic of microcredit. As these fees represent an inherent cost of borrowing, they must also be added to the charge for interest in order to show the effective APR.

Benefits of flat rate lending

Flat interest rates have the following advantages:

They are easy to calculate and track: Flat interest rates require no calculations to blend principal and interest into a level payment and, as long as these are made on time, require no compounding calculations (see the example to the right). Flat rates keep loan commitments clear, transparent and easily tracked by both parties. Many microfinance institutions do not have computers, so the complexity of true, declining balance calculations may confuse their borrowers and even their staff. Semi-formal institutions like self-help groups, village banks and ASCAs also usually prefer the flat rate method.
They meet vital cash flow needs of farmers: Many borrowers in developing countries are farmers who demand loans with balloon payments, repayable after they harvest their crops. When the borrower has use of the full amount of principal throughout the entire loan term, flat rate calculations equate to true rate. For farmers accustomed to these types of transactions, flat rate cash loans are familiar and easy to understand.
They support 'in-kind' loan transactions: As mentioned above, flat rate loans originated before currency was invented, and are commonly used to repay loans in regular instalments of chickens, eggs, kilos of rice, and so on.

Interest is payment from a borrower or deposit-taking financial institution to a lender or depositor of an amount above repayment of the principal sum, at a particular rate. It is distinct from a fee which the borrower may pay the lender or some third party. It is also distinct from dividend which is paid by a company to its shareholders (owners) from its profit or reserve, but not at a particular rate decided beforehand, rather on a pro rata basis as a share in the reward gained by risk taking entrepreneurs when the revenue earned exceeds the total costs.

A self-help group (SHG) is a financial intermediary committee usually composed of 10–20 local women or men. Most self-help groups are located in India, though SHGs can be found in other countries, especially in South Asia and Southeast Asia. SHG is nothing but a group of people who are on daily wages, they form a group and from that group one person collects the money and gives the money to the person who is in need.

Village banking is a microcredit methodology whereby financial services are administered locally rather than centralized in a formal bank. Village banking has its roots in ancient cultures and was most recently adopted for use by micro-finance institutions (MFIs) as a way to control costs. Early MFI village banking methods were innovated by Grameen Bank and then later developed by groups such as FINCA International founder John Hatch. Among US-based non-profit agencies there are at least 31 microfinance institutions (MFIs) that have collectively created over 800 village banking programs in at least 90 countries. And in many of these countries there are host-country MFIs—sometimes dozens—that are village banking practitioners as well.

Problems with flat rate lending

Flat interest rates have the following disadvantages:

They are complicated by early or late payments: If a loan calls for repayments at regular intervals but these are not made when due, the total cost of credit and those repayments are inapplicable; interest must be recalculated based on (a) the amount outstanding from time to time and (b) the true rate. If the loan is repaid ahead of time, refusing to allow an interest discount would be unfair to borrowers and remove the incentive to honour their legal obligations early. Conversely, if the loan is repaid late, failing to apply additional interest would be unfair to lenders and encourage borrowers to dishonour their legal obligations. In either case, it is a mistake to claim that that "flat" means "fixed" in the sense of the original total cost of credit. Writing of the practices of microfinance institutions in Bangladesh, S.M. Rahman points out that "[i]f one client takes a loan today and offers to repay the entire loan the next day, the client has to repay the total loan along with the whole year's interest, reckoned on a flat rate system."^[3]
Their meaning is sometimes confused: The expression "flat rate" is sometimes mistaken for "fixed rate". As mentioned above, flat rate is a method of calculating the total cost of credit if all payments are made on time. Whether or not a rate is variable depends on the terms of the underlying agreement.
They can make it difficult to compare rates: As with weights and measures, a common system is not the only but represents the simplest way of comparing offers. Loans quoted with flat interest rates generally prevail where declining balance calculations are not understandable to most borrowers, which - as mentioned above - is the case almost everywhere. "Not only the clients but even educated people sometimes have trouble understanding this system. The problem is that the flat rate gives an impression of a lower rate than it actually is."^[4] Where loans quoted with declining balance rates are not required by law, flat interest rates are also often used. The latter will be selected by borrowers if they mistakenly believe all rates are comparable without adjustment. Chuck Waterfield, designer of Microfin, a widely used financial modeling tool for MFIs, asks "Why did such a system appear in microfinance lending? The answer is obvious and cannot be debated: it allows the institution to charge nearly twice as much interest for the quoted interest rate as with the declining balance method."^[5]
They may result in undervaluation of a loan portfolio: In addition, flat rate calculations may slightly understate the size of an outstanding loan portfolio which could result in the appearance of a lower average loan size and of a higher yield. Both of these characteristics appeal to donors and external financiers.^[6]

In finance, a portfolio is a collection of investments held by an investment company, hedge fund, financial institution or individual.

In finance, the yield on a security is the amount of cash that returns to the owners of the security, in the form of interest or dividends received from it. Normally, it does not include the price variations, distinguishing it from the total return. Yield applies to various stated rates of return on stocks, fixed income instruments, and some other investment type insurance products.

Towards consumer protection in borrowing

The less developed an economy, the less capacity the government may have to regulate informal lenders. As a result, Brigit Helms argues for an evolutionary approach to interest rates, in which they can be expected to gradually drop as competition increases and the government gains greater capacity to effectively enforce comparable interest rate disclosures on financial sector actors.^[7]

F.W. Raiffeisen as early as 1889, writing to the credit unions then emerging in Germany, campaigned against maintaining the total charge for credit unchanged, even when a loan is repaid early. “It is immoral to charge interest in advance, and also objectionable as a business method. Every member shall have the right at any time to pay back his loan. If interest has been charged for a full year in advance, the members who have made repayments ahead of time, pay too much interest, unless the Credit Union makes a refund.”^[8]

Separately, interest rate ceilings and popular conflation of flat with true rates, has led some institutions to replace or complement interest with transaction fees and other charges, sometimes circumventing disclosure norms consistent with APR. For these reasons, interest is no longer quoted by reference to the flat rate in certain developed countries (for example, in the US, see the Truth in Lending Act), whilst many insist that loans always quote the APR.

Nevertheless, loans originally quoted and engaged with a flat rate remain contractually valid and still feature widely in both developed and developing countries.

Related Research Articles

Debt deferred payment, or series of payments, that is owed in the future

Debt is when something, usually money, is owed by one party, the borrower or debtor, to a second party, the lender or creditor. Debt is a deferred payment, or series of payments, that is owed in the future, which is what differentiates it from an immediate purchase. The debt may be owed by sovereign state or country, local government, company, or an individual. Commercial debt is generally subject to contractual terms regarding the amount and timing of repayments of principal and interest. Loans, bonds, notes, and mortgages are all types of debt. The term can also be used metaphorically to cover moral obligations and other interactions not based on economic value. For example, in Western cultures, a person who has been helped by a second person is sometimes said to owe a "debt of gratitude" to the second person.

Loan transfer of money that must be repaid

In finance, a loan is the lending of money by one or more individuals, organizations, or other entities to other individuals, organizations etc. The recipient incurs a debt, and is usually liable to pay interest on that debt until it is repaid, and also to repay the principal amount borrowed.

Microfinance is a category of financial services targeted at individuals and small businesses who lack access to conventional banking and related services. Microfinance includes microcredit, the provision of small loans to poor clients; savings and checking accounts; microinsurance; and payment systems. Microfinance services are designed to be more affordable to poor and socially marginalized customers and to help them become self-sufficient.

A variable-rate mortgage, adjustable-rate mortgage (ARM), or tracker mortgage is a mortgage loan with the interest rate on the note periodically adjusted based on an index which reflects the cost to the lender of borrowing on the credit markets. The loan may be offered at the lender's standard variable rate/base rate. There may be a direct and legally defined link to the underlying index, but where the lender offers no specific link to the underlying market or index the rate can be changed at the lender's discretion. The term "variable-rate mortgage" is most common outside the United States, whilst in the United States, "adjustable-rate mortgage" is most common, and implies a mortgage regulated by the Federal government, with caps on charges. In many countries, adjustable rate mortgages are the norm, and in such places, may simply be referred to as mortgages.

A reverse mortgage is a mortgage loan, usually secured over a residential property, that enables the borrower to access the unencumbered value of the property. The loans are typically promoted to older homeowners and typically do not require monthly mortgage payments. Borrowers are still responsible for property taxes and homeowner's insurance. Reverse mortgages allow elders to access the home equity they have built up in their homes now, and defer payment of the loan until they die, sell, or move out of the home. Because there are no required mortgage payments on a reverse mortgage, the interest is added to the loan balance each month. The rising loan balance can eventually grow to exceed the value of the home, particularly in times of declining home values or if the borrower continues to live in the home for many years. However, the borrower is generally not required to repay any additional loan balance in excess of the value of the home.

The term annual percentage rate of charge (APR), corresponding sometimes to a nominal APR and sometimes to an effective APR (EAPR), is the interest rate for a whole year (annualized), rather than just a monthly fee/rate, as applied on a loan, mortgage loan, credit card, etc. It is a finance charge expressed as an annual rate. Those terms have formal, legal definitions in some countries or legal jurisdictions, but in general:

Amortization (business) spreading payments over multiple periods; the term is used for two separate processes: amortization of loans and amortization of assets. In the latter case it refers to allocating the cost of an intangible asset over a period of time

In business, amortization refers to spreading payments over multiple periods. The term is used for two separate processes: amortization of loans and amortization of assets. In the latter case it refers to allocating the cost of an intangible asset over a period of time.

Credit is the trust which allows one party to provide money or resources to another party wherein the second party does not reimburse the first party immediately, but promises either to repay or return those resources at a later date. In other words, credit is a method of making reciprocity formal, legally enforceable, and extensible to a large group of unrelated people.

In finance, negative amortization occurs whenever the loan payment for any period is less than the interest charged over that period so that the outstanding balance of the loan increases. As an amortization method the shorted amount is then added to the total amount owed to the lender. Such a practice would have to be agreed upon before shorting the payment so as to avoid default on payment. This method is generally used in an introductory period before loan payments exceed interest and the loan becomes self-amortizing. The term is most often used for mortgage loans; corporate loans with negative amortization are called PIK loans.

A balloon payment mortgage is a mortgage which does not fully amortize over the term of the note, thus leaving a balance due at maturity. The final payment is called a balloon payment because of its large size. Balloon payment mortgages are more common in commercial real estate than in residential real estate. A balloon payment mortgage may have a fixed or a floating interest rate. The most common way of describing a balloon loan uses the terminology X due in Y, where X is the number of years over which the loan is amortized, and Y is the year in which the principal balance is due.

A commercial mortgage is a mortgage loan secured by commercial property, such as an office building, shopping center, industrial warehouse, or apartment complex. The proceeds from a commercial mortgage are typically used to acquire, refinance, or redevelop commercial property.

This page gives descriptions of UK mortgage terminology which can often confuse borrowers.

Mortgage calculators are automated tools that enable users to determine the financial implications of changes in one or more variables in a mortgage financing arrangement. Mortgage calculators are used by consumers to determine monthly repayments, and by mortgage providers to determine the financial suitability of a home loan applicant.

In banking and finance, an amortizing loan is a loan where the principal of the loan is paid down over the life of the loan according to an amortization schedule, typically through equal payments.

Mortgage loan loan secured using real estate

A mortgage loan or, simply, mortgage is used either by purchasers of real property to raise funds to buy real estate, or alternatively by existing property owners to raise funds for any purpose, while putting a lien on the property being mortgaged. The loan is "secured" on the borrower's property through a process known as mortgage origination. This means that a legal mechanism is put into place which allows the lender to take possession and sell the secured property to pay off the loan in the event the borrower defaults on the loan or otherwise fails to abide by its terms. The word mortgage is derived from a Law French term used in Britain in the Middle Ages meaning "death pledge" and refers to the pledge ending (dying) when either the obligation is fulfilled or the property is taken through foreclosure. A mortgage can also be described as "a borrower giving consideration in the form of a collateral for a benefit (loan)".

In finance, the weighted-average life (WAL) of an amortizing loan or amortizing bond, also called average life, is the weighted average of the times of the principal repayments: it's the average time until a dollar of principal is repaid.

Zidisha is a 501(c)(3) non-profit organization that allows people to lend small amounts of money directly to entrepreneurs in developing countries. It is the first peer-to-peer microlending service to link borrowers and lenders across international borders without a local microfinance institution intermediary. The organization is named after the Swahili word zidisha, which means "grow" or "expand".

References

↑ Chuck Waterfield. 'The role of interest rates in microfinance'. In Microfinance India: State of the Sector Report 2008 (N. Srinivasan, Sage Publications, Los Angeles, New Delhi, 2009), p. 63.
↑ For detailed comparison of amortization charts, see Consultative Group to Assist the Poorest, 'Microcredit interest rates' Occasional Paper #1, August 1996, pp. 4-8
↑ S.M. Rahman. A practitioner's view of the challenges facing NGO-based microfinance in Bangladesh. In Thomas Dichter and Malcolm Harper (eds.) What's Wrong with Microfinance? Intermediate Technology Publications Ltd., Warwickshire, UK, 2007, p. 198.
↑ S.M. Rahman in Dichter & Harper, p. 198.
↑ Waterfield in Srinivasan, p. 63.
↑ 'Microcredit interest rates', p. 9
↑ Brigit Helms & Xavier Reilly. Microfinance interest rates: the story so far. Consultative Group to Assist the Poor, Sept, 2004, p. 15
↑ F.W. Raiffeisen, The Credit Unions. Eighth edition, December 1966, The Raiffeisen Printing and Publishing Co., Neuwied on the Rhine, Germany. Translated to English by Konrad Engelmann. p. 74.

This page is based on this Wikipedia article
Text is available under the CC BY-SA 4.0 license; additional terms may apply.
Images, videos and audio are available under their respective licenses.

[1] Chuck Waterfield. 'The role of interest rates in microfinance'. In Microfinance India: State of the Sector Report 2008 (N. Srinivasan, Sage Publications, Los Angeles, New Delhi, 2009), p. 63.

[2] For detailed comparison of amortization charts, see Consultative Group to Assist the Poorest, 'Microcredit interest rates' Occasional Paper #1, August 1996, pp. 4-8

[3] S.M. Rahman. A practitioner's view of the challenges facing NGO-based microfinance in Bangladesh. In Thomas Dichter and Malcolm Harper (eds.) What's Wrong with Microfinance? Intermediate Technology Publications Ltd., Warwickshire, UK, 2007, p. 198.

[4] S.M. Rahman in Dichter & Harper, p. 198.

[5] Waterfield in Srinivasan, p. 63.

[6] 'Microcredit interest rates', p. 9

[7] Brigit Helms & Xavier Reilly. Microfinance interest rates: the story so far. Consultative Group to Assist the Poor, Sept, 2004, p. 15

[8] F.W. Raiffeisen, The Credit Unions. Eighth edition, December 1966, The Raiffeisen Printing and Publishing Co., Neuwied on the Rhine, Germany. Translated to English by Konrad Engelmann. p. 74.