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Jason, a twenty something executive took a personal loan of RM10,000 at a flat interest rate of 8.5% p.a. for 36 months to renovate his newly bought apartment. He is happy with his decision, at 0.71% per month, 8.5% p.a. is the lowest he can find as compare to the others at 12% p.a.

But did Jason really manage to get it so cheap?

Jason was yet another customer who got sucked by the flat rate that that does not reflect the actual cost of his loan.

“Flat interest rates” are not interest rates per se but rather a simple percentage often used to disguise the true (i.e. higher) interest rate. Very often banks offer flat interest rate because it sounds good and is easy to understand for average consumers.

The actual cost of a flat rate loan is much higher because the borrower is always paying the loan interest based on the initial amount (principal) borrowed even though the principle has been gradually reduce during the loan tenure. In Jason case, his 1st year interest rate is based on RM10,000, and the 2nd & 3rd year interest rate is still based on the RM10,000

So what exactly Jason is paying for his ‘cheap’ loan?

• Firstly, the actual monthly interest rate is 1.28%, not 0.71%
• Secondly, the annual percentage rate is 15.4%, not 8.5% (1.28% x 12)
• Thirdly and most importantly, the actual cost of the loan i.e., the effective interest rate (EIR) is 16.5%.

’’Effective rate of interest’’ is the most useful tool to understand the real cost of a loan. Interest rate on loan is a slippery road, always walk with great caution. Do not fall flat on what is quoted, always insists the lender to show the EIR before signing any loan agreement.

But Jason story is not finished yet, in calculating the EIR, the loan processing fees, which is usually deducted from the loan disbursement, is excluded. By taking into account of the various processing fees, the final EIR is 19.1% where a monthly interest rate is 1.47% (almost equivalent with credit card at 1.5%). Read more on this and EIR on PART II of this article.

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