Understanding Flat and Effective Interest Rate

Generally speaking, P2P Lending is considered more competitive than bank interest. It because of interest set into prospective borrowers credit score. The interest amount accordance with the provisions of a platform analysis. For information, interest offered can reach 17-25% per year.

Loan or credit facilities provided by P2P Lending to investors have different interest calculation methods. Generally, there are three types of interest calculation methods that are often applied, namely flat interest, effective interest, and annuity interest. However, in P2P Lending mostly applies two kinds of interest; flat and effective interest rates.

So, what is the difference between flat and effective interest rates?

1. Flat interest rate

Flat interest rate is a system of interest stipulation imposed by banking institutions and financing institutions which is calculated based on the initial loan principal. In this type of interest rate, the portion will same every month.

For example: if you borrow 240 million rupiahs with a flat interest rate of 10% and a tenor for 1 year and a principal fund every month is 20 million.

Then, for the payment of interest every month
240 million x 10% / 12 months = 2,000,000 rupiah. The interest amount you will pay is same until the end of the period.

The advantage of this type of interest rate is the certainty that the portion that must be paid every month, provides more stability than the effective interest rate. Thus, the penalty fee given is relatively smaller. However, the weakness of flat interest rate when interest rates per year have decreased. The customers will not be able to enjoy it, because the interest rate has been set at the beginning.

2. Effective Interest Rate

In general, the effective interest rate follows the interest rate prevailing in the market or accordance with the policies of Bank Indonesia (BI Rate). So, the basis for calculating the effective interest rate is based on remaining loan principal, not the initial loan principal. Therefore, the portion that must be paid by borrower will be different every month.

Finance institutions and banking institutions also use this type of interest more often as a model for repaying their debts. Because interest as income will be obtained by investors from the start.

Some people think that the calculation of this interest rate more difficult. However, in general, the calculation is:

SP x i x (30/360)
SP = balance of principal of the previous month
i = interest rate per year
30 = number of days in a month
360 = number of days in a year

Suppose someone is applying for a loan Rp 240,000,000.00 with one year period and the interest rate 10%/year. with a principal amount is 20 million rupiahs, the calculation will be like:

= IDR 240,000,000.00 x 10% x (30/360) = Rp 2,000,000.00

Then, amount for the second month: = IDR 240,000,000.00 - IDR 2,000,000.00 = IDR 238,000,000.00
Then use the formula:
= IDR 238,000,000.00 x 10% x (30/360) = Rp 1,983,333

The interest amount in the third month:
IDR 238,000,000 - IDR 1,983,333
= Rp 236,016,667 x 10% x (30/360) = Rp. 1,966. 805

(The amount will be different every month, until the end of the period)

This interest rate advantage, when interest in market decrease. It will make the value become small too. In addition, the interest rate is relatively smaller, because the interest calculation is based on the remaining principal loan. The weakness of the effective interest rate, when the interest rate for the year increase, the total interest that must be paid can also increase.

Overall, both lenders or borrowers need to understand the differences and how to calculate interest so that they are not wrong to make comparisons. Not only look at the difference in interest rates number on the loan but also the type and interest calculations method.