The 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 3,00,000 in interest and an EMI of 15,000. Now price the same six lakh at a genuine ten percent reducing balance. The interest is about 1,65,000 and the EMI is 12,748.

Same loan. Same advertised rate. The flat version costs 1,35,000 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.

What the flat rate charges interest on

The whole trick fits in one picture. On a reducing balance loan, the amount you owe falls with every EMI, and so does the interest. A flat rate keeps charging on the starting amount for all five years.

On average over the five years, a reducing balance loan has only a little over half the principal outstanding. A flat rate charges on all of it. That is why the true rate comes out close to double the quoted one.

The two loans, side by side

I checked the opening's true rate: an EMI of Rs 15,000 for 60 months on Rs 6 lakh is the same cash flow as a reducing balance loan at about 17.27 percent a year. The 1.8 times rule is a good tell, and it drifts a little with the rate. On the same loan, a flat 8 percent works out to about 14.1 percent reducing, 1.77 times, and a flat 12 percent to about 20.3 percent, 1.69 times.

Flat quotes tend to show up where the loan is sold at the point of purchase: vehicles, consumer durables, some personal and education loans offered through a dealer or an app. The EMI is usually what the buyer is asked to approve, and the rate is a sales line. That is why the opening's fix works everywhere. The EMI and the number of months are in the contract, and from those two numbers the real interest and the real rate follow without any help from the lender.

Check any offer yourself

The disclosure that settles it

Regulation now gives you the number directly. The RBI's circular on the Key Fact Statement for loans, issued on 15 Apr 2024 and applicable to new retail and MSME term loans from 1 Oct 2024, requires lenders it regulates to give borrowers a standard summary before the loan is signed. It includes the annual percentage rate, the all in cost of the loan on a yearly basis, along with the repayment schedule. A flat 10 percent quote and a 17 percent annual percentage rate on the same page cannot both pass unnoticed.

The free Learn module on leverage, debt and financial risk treats a household loan the way an analyst treats a company's debt, with the same coverage questions. Related: prepay the loan or invest and the minimum due trap.