The term flat interest rate is sometimes used in relation to flat rate finance loan agreements (particularly car loans) to show the rate of interest based on the original principal loan amount (PV). The flat rate does not take account of the reducing loan balance as payments are made, and therefore does not provide a true reflection of the actual interest rate being charged and can be misleading.
Flat Interest Rate Example 1
Suppose for example, a car loan for 8,640 (PV), has monthly payments of 200 (Pmt), for a term of 48 months (n), then the flat interest rate would be calculated as follows:
Principal repayment each month = Principal / Term Principal repayment each month = 8,640 / 48 = 180 Monthly interest = Pmt - Principal repayment Monthly interest = 200 - 180 = 20 Annual interest = 20 x 12 = 240 Flat interest rate = Interest / Principal (PV) Flat interest rate = 240 / 8,640 Flat interest rate = 2.778%
The flat interest rate is calculated by dividing the annual interest by the original loan amount
Flat Interest Rate Formula
In general the flat interest rate can be calculated using the flat interest rate formula.
Using the values in the example above, the flat interest is calculated using the formula as follows:
i = Flat interest rate = (Pmt - PV / n) / PV n = Number of periods = 48 PV = Present value = 8,640 Pmt = Periodic payment = 200 Flat interest rate = (200 - 8,640 / 48) / 8,640 Flat interest rate = 0.2315% per month Annual rate = 12 x 0.2315% = 2.778%
Flat Rate vs APR
Of course in practice, the principal loan balance is reduced by the payment each month, and the interest is calculated on the principal balance at the start of each month.
The interest rate (APR) is given by the present value of an annuity formula or alternatively by the Excel RATE function.
Using the same values as in the flat interest rate example
n = 48 Pmt = 200 PV = 8,640 i = RATE(48,-200,8640) i = 0.4385% per month APR = 12 x 0.4385% = 5.262%
This calculation shows that the flat rate of interest of 2.778% is equivalent to an APR of 5.262%. To show this is the case, we can compare the total interest for each rate.
Total Interest Using the Flat Interest Rate
Using the flat interest rate the total interest is:
Interest = Principal x Rate X Term Interest = 8,640 x 2.778% x 4 = 960
Total Interest Using the APR Interest Rate
Using the APR interest rate the total interest is:
Pmt = PV x i / (1 - 1 / (1 + i)n) Pmt =8640 x (5.262%/12)/(1-1/(1+5.262%/12)48 Pmt = 200 Interest = Pmt x n - PV Interest = 200 x 48 - 8,640 Interest = 960
Flat Interest Rate Example 2
To show the effect of the two interest rates, consider another example of a loan of 3,000 paid off over 4 months with payments of 780 a month. The two rates are calculated as before using the formulas discussed above.
Flat interest rate = (780 - 3,000 / 4) / 3,000 Flat interest rate = 1% or 12% a year APR = RATE(4,-780,3000) = 1.5875% = 19.05% a year
If we now look at the payment schedules for each interest rate we get the following:
|Month 1||Month 2||Month 3||Month 4|
|Month 1||Month 2||Month 3||Month 4|
The flat interest rate schedule calculates interest at 1% on the opening principal balance of 3,000, whereas the APR interest rate schedule calculates interest at 1.5875% on the reducing balance at the start of each month. Both schedules show the loan reducing from 3,000 to zero over the 4 month period with monthly payments of 780, and a total interest charge of 120.
Flat Rate to Effective Interest Rate
Finally, the effective annual interest rate can be calculated using the APR with the standard formula as follows:
EAR = (1 + r / m )m - 1 r = Annual nominal rate of interest = 1.5875% m = Number of compounding periods in a year = 12 EAR = (1 + 1.5875% )12 - 1 EAR = 20.805%
To summarize for this example, a flat rate of 12% is equivalent to an APR of 19.05% which is equivalent to an effective annual rate (EAR) of 20.805%.
About the Author
Chartered accountant Michael Brown is the founder and CEO of Double Entry Bookkeeping. He has worked as an accountant and consultant for more than 25 years and has built financial models for all types of industries. He has been the CFO or controller of both small and medium sized companies and has run small businesses of his own. He has been a manager and an auditor with Deloitte, a big 4 accountancy firm, and holds a degree from Loughborough University.