We often stumble across the terms “Flat Rate Interest” and “Reducing Balance Rate” when applying for loans, but do we truly understand the difference between the two types of interest? Although these terms may sound like financial jargons, they are relatively simple to understand. The truth is most of us take the easy route and depend on our bankers to do the calculations for us.
That said, it’s best to keep informed on these finances so we have a good idea when the time comes. Here’s our explanation on their differences and calculations, made simple to help you manage your own finances.
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Flat Rate Interest
When we think of interest, most of us think of flat rate interest. Flat Rate Interest is the type of interest that will stays the same on the principal loan amount throughout your loan tenure. This means that whatever interest rate you are charged at the beginning of the loan payment will remain the exact same figure as your final month’s repayment. It is popularly used in personal loans and hire purchase (car) loans.
(Original Loan Amount x Number of Years x Interest Rate Per Annum) ÷ Number of Instalments = Interest Payable Per Instalment
Say for example, you’re taking out a personal loan of RM100,000 with a flat rate interest of 5.5% over 10 years. This would be your flat rate interest per instalment calculation:
(RM100,000 x 10 x 5.5%) ÷ 120 = RM458
Now, do note that this is just the interest per instalment, no matter how much you have paid down on your principal loan amount. Theoretically, your monthly instalment from your loan amount of RM100,000 should be RM834 per month (RM100,000 ÷ 120 months). Combining both (RM834 + RM458), you’ll be paying RM1,292 per month for your loan repayment over a period of 120 months (10 years).
At the end of your loan tenure, you would end up paying 35.5% interest (also known as the Effective Interest Rate, EIR), which rounds up your repayment amount to RM155,040. That’s RM55,040 more than what you originally borrowed! It’s no surprise then that a Flat Rate Interest is not a popular choice amongst borrowers. No matter how much you settle on your principal loan amount, the interest amount will stay constant ending up in a higher total paid at the end of your loan tenure.
You can read more about Effective Interest Rates in a hire purchase loan here.
Reducing Balance Rate
Also known as the Diminishing Balance Rate, the Reducing Balance Rate is used in financial products, especially for mortgage loans; even overdraft facilities and credit cards – and is the preferred option compared to the Flat Interest Rate. Why? Because it only charges interest on your loan’s remaining balance.
To give you a clearer picture, below is the first year’s repayment period calculation based on the same example above:
Needless to say, Reducing Balance Rate enables you to save a lot more as your loan tenure goes by, following the balance of your loan’s principal amount. You end up paying less interest while paying off more principal amount with each passing month.
Based on the calculations above, your loan’s monthly repayment may remain the same while the allocated amount to both interest and principal loan is different each month. This is because the interest charged on the principal loan amount reduces each month as you continue to pay down your principal loan amount.
The total interest paid at the end of your loan tenure will be RM30,232 with the total repayment being RM130,232. That’s a whopping difference of RM24,808 compared to the Flat Interest Rate option.
Interest amount per instalment = Interest rate per instalment x Outstanding loan amount
Although more calculations are input for this type of interest, the formula is fairly simple.
While the Reducing Balance Rate seems a lot more appealing than Flat Interest Rate, not all loan providers offer it for their financial products. All the same, it’s best to understand the calculation methods and difference between the two types and details about loans to help you make informed decisions on your finances.
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