If you’re considering applying for a personal loan, car loan or housing loan, understanding the difference between effective interest rate vs flat rate is crucial.
This article explains the intricacies of both rates, highlighting their formulas, advantages, and scenarios where each is applied.
By understanding the differences between these two rates, you can make more informed decisions regarding loan agreements offered by various banks.
Effective Interest Rate vs Flat Rate in Malaysia
These two interest rate structures represent different ways of calculating the interest you’ll pay on your loan and can have a significant impact on the total cost of borrowing.
1. Flat Rate
The flat rate method involves applying a simple interest rate to the initial principal amount, which remains constant throughout the loan term.
This means the interest is calculated as a fixed percentage of the original loan amount and does not change, regardless of how much principal has been repaid.
Here’s an example to better illustrate the calculation:
Situation A
Mrs Lee applied for a loan from Bank A for RM100,000 with a loan term of 8 years and a flat rate of 8%.
Monthly payment = [(RM100,000 × 8% × 8) + RM100,000]/(8 × 12)
Total interest cost at the end of loan term: RM100,000 × 8% × 8 = RM64,000
Total loan repayment amount at the end of the loan term = RM100,000 + RM64,000
= RM164,000
Monthly payment = RM164,000/96 = RM1,708
Her monthly instalment will be RM1,708 per month for 8 years.
2. Effective Interest Rate
The Effective Interest Rate, or EIR, offers a more accurate measure of the true cost of borrowing or investing over a specified period.
It includes the nominal or stated interest rate and any additional fees, taking into account the compounding frequency. This allows for a more informed comparison between different loan products.
Now, let’s revisit Mrs. Lee’s situation with an EIR of 8%:
Situation B
Mrs Lee applied for a loan from Bank A for RM 100,000 with 8 years of the loan term, with an effective rate of 8%.
Here, the interest charged for the first year would be RM8,000, similar to situation A.
However, in the second year, the interest is calculated based on the outstanding loan balance at the start of year 2.
Assuming Mrs Lee makes an RM20,000 payment in year 1, the outstanding loan balance at the start of year 2 is RM88,000.
The interest cost for the year 2 is then calculated as RM88,000 x 8% = RM7,040, which is lower than the flat rate interest of RM8,000 for the same period.
Read More: What is the Personal Loan Process in Malaysia
What is the Difference Between Effective Interest Rate vs Flat Rate in Malaysia
1. Calculation Method
EIR is a comprehensive calculation that takes into account the nominal interest rate, other fees, charges, and the amortisation schedule of the loan. It reflects the true cost of borrowing.
On the other hand, the flat rate is calculated solely based on the initial principal amount of the loan.
Hence, it remains constant throughout the entire loan term and does not reflect the actual cost over time.
2. Interest Amount Over Time
With EIR, the interest amount varies over time as the outstanding loan balance decreases with each payment. This results in lower interest costs as the loan is repaid.
The interest amount with a flat rate remains the same throughout the loan or investment term.
This means that the total monthly interest cost is constant, no matter how much of the principal has been repaid.
3. Transparency
EIR provides borrowers with a more transparent and accurate understanding of the total cost of borrowing. It accounts for all relevant terms and conditions.
A flat rate can be less transparent because it does not consider factors such as amortisation or additional fees.
This can potentially lead borrowers to underestimate the true cost of borrowing.
4. Comparison of Loan Products
EIR allows for easier and more accurate comparisons between different loan products from various banks or financial institutions.
Borrowers can compare the EIR to assess the true cost of borrowing and make informed decisions.
Comparing loans with flat rates can be challenging because they do not reflect the true cost of borrowing. Different loans with flat rates may have varying terms and fee structures.
5. Total Cost of Borrowing in Malaysia
EIR offers a more accurate representation of the total cost of borrowing, considering the interest, fees, and amortisation schedule. Borrowers can plan for their loan payments more effectively.
A flat rate may result in borrowers paying more interest over the life of the loan, especially if they repay the loan earlier than the original term.
Read More: Should You Use Your EPF Savings to Apply for a Personal Loan
Why is it Important to Understand the Effective Interest Rate vs Flat Rate in Malaysia
1. Accurate Cost Assessment
Knowing the difference between effective interest rate vs flat rate enables you to accurately assess the true cost of borrowing.
For example, EIR provides a fuller picture by factoring in additional fees, charges, and the amortisation schedule.
2. Informed Decision-Making
Understanding EIR helps you to better compare loan offers from different banks or financial institutions on an apple-to-apple basis.
It ensures you are comparing the total cost of borrowing, which can vary significantly between loan types with different interest rate structures.
To calculate the estimated EIR of a loan with a flat rate, you can multiply it by 2. As such, a flat rate of 8% per annum would be equivalent to an EIR of 16% per annum.
3. Better Financial Planning
The effective interest rate facilitates more effective financial planning. You can anticipate your loan payments over time, making it easier to budget and manage your cash flow.
4. Protection from Misleading Loan Offers
EIR promotes transparency and protects borrowers from falling victim to misleading loan offers that emphasise a low flat rate without disclosing other hidden fees or unfavourable terms.
Read More: How Does a Personal Loan Affect Credit Score in Malaysia
Know More about Effective Interest Rate vs Flat Rate
Bluebricks can help you compare the various financial products in the market and clarify effective interest rate vs flat rate to choose the most suitable loan product for your needs.
Trusted by numerous clients in Malaysia’s financial industry, Bluebricks offers a broad range of financial solutions to help you achieve your goals, including:
- Personal loan services
- SME loan rejected services
- Mortgage loan rejected services (for buying a new home, refinancing and cashback purposes)
- Collateral loan services
Comprehensive Loan Consultancy Services in Malaysia
Our consultation process aims to provide clearer insight into your financial standing, guiding you towards the most suitable loan option tailored to your specific needs.
We carefully consider several key aspects, including:
- The specific loan amount you require.
- The urgency with which the loan amount is needed.
- Whether you or your parents own a property that has been held for over ten years.
- Your income level.
- Your CTOS score (such as your credit score and credit history).
Effective Interest Rate vs Flat Rate – FAQs
When you’re comparing and looking into loan products, you may come across unfamiliar terminologies and concepts.
Thus, we have put together a list of commonly asked questions to further clarify your doubts about the total cost of borrowing for a loan.
The details of the effective interest rate or flat rate can typically be located in the Product Disclosure Sheet (PDS) or on the loan product’s web page.
However, it might not be shown obviously. If you are unable to get the information, it’s best to reach out to the bank or financial institution to request for it.
When it comes to a flat rate, you will be charged interest based on the full duration of your loan.
Moreover, you may have to pay a penalty fee should you decide to repay your loan early during the lock-in period.
Loan providers may advertise flat rates due to their lower percentages to make their loan products more appealing.
However, regulations may also require them to display the effective interest rate to provide a more transparent view of the loan’s cost.
Borrowers should compare loans using the effective interest rate rather than the flat rate.
This is because EIR provides a more accurate comparison of the costs involved in different loan offers.
