Updated 12 April 2018.
We often stumble across the terms Flat Rate Interest and Reducing Balance Rate when applying for loans, but do you really understand the difference between the two types of interest? Do you know how to calculate them, or do you rely on your banker to do all the calculations for you?
Don’t keep yourself in the dark, especially when it involves your finances. Here’s our explanation on their differences and calculations, made simple to help you manage your own finances.
Flat Rate Interest
In the simplest of terms, Flat Rate Interest is the type of interest that will stay the same on the principal loan amount, throughout your loan tenure. This means that whatever interest rate that you’re charged at the time you take out the loan will remain the exact same figure as your final month’s loan repayment. It’s generally used in personal loans and hire purchase (car) loans.
Here’s a very simple formula to calculate Flat Rate Interest:
(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 RM50,000 with a flat rate interest of 7% over 5 years. This would be your flat rate interest per instalment calculation:
(RM50,000 x 5 x 7%) ÷ 60 = RM292
Now, do note that this is just the interest per instalment, no matter how much you have paid down on your principal loan amount. Logically speaking, your monthly instalment from your loan amount of RM50,000 should be RM834 per month (RM50,000 ÷ 60 months). Combining both of them (RM833 + RM292), you’ll be paying RM1,125 per month for your loan repayment over the period of 60 months (5 years).
At the end of your loan tenure, you would end up paying 35% interest, which rounds up your repayment amount to RM67,500. That’s RM17,500 more than what you originally borrowed. This is exactly the reason why Flat Rate Interest is not a favored choice amongst borrowers, because no matter how much you pay down your principal loan amount, the interest amount will stay constant.
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 to many 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 using the same example as above:
Needless to say, Reducing Balance Rate benefits you in the sense that you pay a lot less as your loan tenure goes by, following the balance of your loan’s principal amount. As you can see from the table, although your loan’s monthly repayment may remain the same, the amount paid to both interest and principal loan is different each month. This is because the interest charged on the principal loan amount gets lower 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 RM9,404, with the total repayment being RM59,404. That’s a difference of RM8,096 when you compare it to the Flat Interest Rate option.
Although more calculations are needed for this type of interest – as you’ll need to calculate it every month – the formula is fairly simple:
Interest amount per instalment = Interest rate per instalment x Outstanding loan amount
Of course, 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 important to know the calculation and difference between both as well as details about loans you need to know to enable you to make better decisions for your finances.
We at CompareHero.my strive to empower Malaysians with financial literacy and the tools to make better financial decisions in life. Find and compare the best personal loans on CompareHero.my today!
Originally written by Syaza Abd Jani, CompareHero.my Content Writer in 2016.