I just read the wikipedia article http://en.wikipedia.org/wiki/Flat_rate_(finance) and am simply baffled by the alleged “problems” with the method.
If the effective APR is bigger than it sounds like, why not just publish both numbers? Besides, the lenders might focus on actual payment schedule and not any abstract interest rates anyway. Well, and if the microlenders are criticized specifically for charging too high an effective APR, why don’t the critics just tell them to reduce the flat rate interest and the resulting APR?
If the problem with pure flat rate is that it discourages early repayment (see the argument of F.W. Raiffeisen in wikipedia article), why not add explicit provisions for early repayment which are just as crystal clear and unambiguous as the flat rate payments themselves?
So I guess to me right now the criticism sounds like an attempt to throw out the baby with the bathwater. If people find flat rate type payment schedules easy to understand, then why should the idea be scrapped because allegedly some lenders are doing business insufficiently charitably, or because some eggheads like complex accounting models more than simple-to-understand ones?
Basically it works out that borrowers pay a penalty based on their ignorance or lack of access to more sophisticated borrowing methods. Same reason that check-advance lenders are looked down on, really. Banks can offer flat-rate loans at “market rate” to their poorest customers, exploiting their ignorance to earn a premium. At the same time, they offer standard fixed-rate loans to customers savvy enough to know the difference. Sure, it’s a smart (if ruthless) business practice from the bank’s point of view. But from a larger societal perspective, it means that the poor have more barriers to economic improvement. It’s another example of why being poor costs a lot of money.
A loan contract gives / enables the bank opportunities to charge penalties during the life of the loan.
A late payment fee.
lazybratsche, did you actually read my counter-arguments? If Mr. Yunus, let’s say, think that the poor dumb borrowers are being overcharged because they focus more on official percent rate than on the actual repayment schedule (ok, you see, Asok, on Monday you bring me $10 and then next Monday you bring more $10 more, for 10 Mondays - got it?) and so end up paying more than what would make sense given their expected default rate, why doesn’t he just open a competing flat rate lender shop that charges lower interest rate? If Mr. Asok, for the sake of argument (and according to “pro” position cited in wikipedia), would prefer borrowing under flat rate terms rather than more traditional terms, why doesn’t Mr. Yunus or any other new market entrant accommodate him?
Well, code_grey, in developed countries there are basically two different types of loans. Let’s consider the case of a loan of $1,200 at 12% for one year, monthly payments.
The first is a simple interest loan. In this case the borrower would pay 11 monthly payments of $12, and then a final payment of 1212 for a total repayment of $1,344. This is the loan that is used when you lend to the U.S. government, for instance. In the base case it is not possible to repay the loan early, but there might be a clause in the agreement to allow repayment with a penalty.
The second is an amortized loan. In this case the borrower would pay 12 monthly payments of 106.62, for a total repayment of 1279.42. This is the form used when a bank loans you money. Typically you can repay the loan early without penalty by repaying the outstanding balance.
The flat-rate loan is considered abusive because if you consider the interest rate as the rate paid on the outstanding balance, it steadily increases throughout the life of the loan. It really has nothing to do with repayment penalties. That last month, when you pay $12 interest on $100 outstanding loan balance, you are paying 144% annual interest.
ETA: The Wikipedia article confuses flat rate loans with simple interest loans, I notice. The example contract shown is a simple interest loan, which is extremely common in developed countries. (Almost) all bonds are simple interest loans.
Reno Nevada, ok, so wikipedia example is wrong. But is there anything right about that article? E.g. when it says that flat rate is real simple to understand and a traditional way to do interest in India, is that right?
Simple interest rate sounds pretty clear to me, no need for Excel or anything. So is the actual flat rate method of accounting the interest somehow simpler than that?
ok, so an example flat rate calculation can be found here http://www.ehow.com/facts_6139546_flat-rate-loan_.html . Hopefully it is more accurate than wikipedia.
Forget my question about simple interest rate above. Obviously this is a horrible way of doing business if your borrowers can blow the money on booze or else get robbed at any time.
Now, back to the amortized loan. I wonder how is Mr. Asok, the not-so-numerate Indian shopkeeper, supposed to tell the difference between a flat-rate loan at rate X and amortized loan at rate Y if in both cases the weekly payment is exactly the same. My hypothesis here is that Mr. Asok does not really care about interest rates or financial terms - he is just thinking in terms of the payment schedule on the calendar. And if it so happens that, when we consider the APR issue, it turns out that short term APR changes over the duration of the loan, then so what? Mr. Asok probably has never heard of the first derivative and does not take it into account in his economic planning; so why should we or Mr. Yunus seek to do otherwise?