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NISM Certifications · NISM-Series-X-A: Investment Adviser (Level 1) · Debt Management and Loans

Anil borrows Rs 1,00,000 for 1 year at 12% p.a., repayable in 12 equal monthly instalments of principal (Rs 8,333.33 each) with interest charged on the original Rs 1,00,000 throughout (a flat rate). The total interest is Rs 12,000. Approximately, what is the effective interest rate on the reducing balance, relative to the flat rate of 12%?

The effective rate is higher than the flat rate, around 21 to 22 percent. A flat rate charges interest on the full original principal even though the balance falls each month, so the average amount actually borrowed is about half, which nearly doubles the true cost.

  1. ALower than 12%, about 6%
  2. BEqual to 12%
  3. CHigher than 12%, about 21-22%Correct
  4. DHigher than 12%, about 13%

Explanation

Because principal is repaid monthly, the average balance outstanding is about half of Rs 1,00,000 (roughly Rs 54,000 to 50,000). Interest of Rs 12,000 on an average balance near Rs 54,000 gives roughly 22%, and the exact IRR is about 21.5%. So the effective rate is far above the 12% flat rate.

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