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When it comes to loans, the interest rates and repayments can be confusing as it is not necessarily a linear model.
Some people rush to pay off their loans, sometimes even paying more than the monthly instalments, thinking that they pay less interest if they finish paying their loan ahead of schedule.
This could be interest on the housing loan, personal loan, car and so on. But at the end of the day, they are still paying the same fixed amount.
The interest rate boils down to how the loan is calculated. There are two types, a flat interest rate (also known as simple interest) and the reducing balance rate.
Flat interest rate
Although the flat interest rate is usually lower, it may be misleading as the interest does not decrease over time.
Regardless of how much you have paid off, you will continue to pay the same amount of interest, which is on the entire loan balance throughout the loan.
Formula for flat interest rate method:(Original loan amount x number of years x interest rate per annum) / number of instalments.
This method is commonly used for personal loans and hire-purchase loans.
Reducing balance interest rate
The second type, the reducing balance interest rate (or diminishing balance rate), is the rate generally used for financial products such as housing, mortgages, property loans, overdraft facilities and credit cards.
Formula for reducing balance rate method: Interest rate per instalment x outstanding loan amount.
To sum it up, every time you make a loan repayment, the interest rate decreases because the interest for the next loan payment is calculated based on the updated unpaid loan amount.
From the two basic formulas above, it may be slightly confusing as to which interest rate is more favourable to borrowers. Let’s take a look at some examples with calculations.
Flat interest rate
Say you take out a personal loan for RM100,000 with a flat interest rate of 5.5% over 10 years.
The calculation for your flat rate interest per instalment would be: (RM100,000 x 10 years x 5%) / 120 = RM458.
This is only for the interest per instalment and does not include the principal loan amount.
The monthly instalment for the loan amount is RM834 per month (RM100,000/120 months). After adding the two together, you will be paying RM1,292 per month throughout the 120 months of your loan repayment.
This means that at the end of your loan tenure, you would have ended up repaying RM155,040. That’s RM55,040 more than the original loan amount.
It is for this reason that flat-rate interest is not a popular choice among borrowers.
Regardless of whether you pay it off early or never missed a payment, the unchanging interest amount results in a higher total paid at the end of the loan tenure.
Reducing balance rate
Here is the calculation for the first year of paying off a loan identical to the above example, except with a reducing balance rate.
It goes without saying that the reducing balance rate helps you to save money along the way, following the balance of your loan’s principal amount.
As time goes by, your monthly instalments, which remain the same, go more to pay off the principal amount than towards interest. The lower the balance of the principal account, the lower the interest amount.
Although this method is slightly trickier to calculate as you will need to input a different set of numbers for each month, it’s clear you will be paying less with a reducing balance rate.
In this scenario, you will have repaid a total of RM130,232 at the end of your loan tenure. That’s a good RM24,808 less than the flat interest rate option.
Bear in mind that although the reducing balance rate seems a lot more appealing, not all financial institutions provide it for their products.
Be sure you know your options and remember to calculate the difference between the two methods first to make a more informed decision on your finances.
This article was written by Adlene Hanna of PropertyAdvisor.my, Malaysia’s most comprehensive source of property data, property analytics and insights.