Flat Rate vs. Effective Rate

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I was once asked,

“Should I take a loan from the bank to invest in unit trusts? Afterall, they’re offering me a low rate of only 3.75% for 5 years”

Should we or shouldn’t we?

Generally, most banks quote a flat rate for personal loans, and not an effective interest rate. Flat rates are also used on car loans.

So if they do quote a flat rate, we need to find out what the effective interest rate is first.

What’s a flat rate?

A flat rate is when interest is calculated on your full principal over the number of years in your loan tenure. So just multiply the rate with the principal, then multiply with the number of years, add back this amount to the principal, then divide with the number of months that you need to pay up the loan.

For example, if you are offered a loan amount of RM 40,000 and the flat rate is 3.75%..

Interest payment  = Rm40,000 x 3.75% = RM 1,500

Total interest paid = RM 1,500 x 5 years = RM 7,500

Instalment amount to be paid per month = (RM 40,000 + RM 7,500) / 60 months = RM 791.66

Use a financial calculator to find out the effective interest rate.

I like to use the EZ Calculators app which you can download on IPhone or Android phones.

flatvseffective

I round up the instalment amount to RM 792 as most banks do that.

…giving us an effective interest rate of 7%.

(You could also borrow some online calculators. I found a couple…..click here or here… to get your effective interest rate from your flat rate)

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So now, to answer the question, “Should I take a loan from the bank to invest? Afterall, they’re offering me a low rate of only 3.75% for 5 years”.

I wouldn’t.

If my loan rate is 7% and my return from my investments give me return of 8%, why bother.

Generally, it’s not healthy to borrow to invest.

Remember that to be regarded as rich and financially free, we need to have a healthy NET WORTH. (total assets less total liabilities)

Thus, borrowing to invest means that not only do we increase our assets, we increase our liabilities, too.

 

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