How to Explain Flat Rate of Interest

A flat rate of interest affects loans of many types, especially auto, home and business loans. The interest rate is the rate that is applied to the loan amount, the added cost of getting the loan that gives the lender profit and adds on to the amount the borrower has to pay back. Loan interest is one of the most important parts of any loan, and comes in different forms, including flat rate interest.

Definition

• Flat rate interest is an interest rate that stays the same throughout the life of the loan. It is a rate that is charged on the full, original amount of the loan no matter when the rate is calculated. This means that when the loan is paid most of the way down, the interest rate that the borrower has to pay is still what it was at the beginning of the loan.

Dividing the Loan Into Payments

• When explaining this flat rate to others, it helps to divide the loan up into payments, just as borrowers do when calculating monthly payments. This makes it easier to see the effects of a flat rate, especially when people are used to seeing interest payments slowly decrease throughout the life of the loan.

Comparisons

• It also helps to compare flat rates to other available rate options. Traditional interest rates are applied to the existing amount of the loan left to be paid, which leads to increasingly lower payments. You can create two separate loan schedules, one for the flat rate and one for a traditional rate, to show how payments continue to stay high with flat rates. You may also include variable rate schedules to point out the difference in this option.

Rule of Thumb

• A common rule of thumb when calculating a flat rate of interest is to take the rate, double it, then subtract one percentage point to arrive at the effective rate per year. If you are explaining a flat interest rate to someone, you can teach them this rule of thumb for a quick analysis of particular loans.

Purposes and Uses

• Flat rates are used by lenders who are willing to give out loans to borrowers, but want extra security to overcome risks of borrower default. However, lenders face a problem: they cannot advertise an extra-high rate for risky borrowers, since this will drive borrowers away. They can use flat rates as way to "hide" the high rate through a difference in loan terms.