Loan Interest Calculation – Reducing Balance VS Flat Interest Rate

When it comes to comparing loans, the stated loan interest rate does not represent everything, and can in fact be deceiving. Aside from loan interest rates, how loan interest is calculated also plays a huge role in your cost of financing.

There are 2 common methods to calculate loan interest in today’s banking system:

1. Reducing balance method
2. Flat interest rate method

Reducing Balance Method

This method is mainly used to calculate the interest payable for housing / mortgage / property loans, overdraft (OD) facilities, and credit cards. You only pay interest on the remaining loan balance. A reducing balance interest calculation formula can be represented like this:
Interest Payable per Installment = Interest Rate per Installment * Remaining Loan Amount
The interest rates quoted for such loans are the Effective Interest Rate, which is the same as the interest rates used for Fixed Deposits (FD) and Savings Accounts.

Flat Interest Rate Method

This method is mainly used to calculate the interest payable for personal loans and car / hire purchase loans. You pay interest on the entire loan balance throughout the duration of the loan. Flat interest rate calculation formula can be represented like this:
Interest Payable per Installment = (Original Loan Amount * No. of Years * Interest Rate p.a. ) / Number of Installments
This is less desirable for the borrower, because even as you pay down the loan, the interest payable does not decrease. If you have difficulty understanding why, consider what would happen if savings accounts used flat interest rate method.
If you put RM1,200 at 10% p.a. in a savings account and withdraw RM100 every month, the bank would still be paying you RM10 in interest every month even though your principal balance would have reduced to only RM100 by Month 12. How cool is that?
As a rule, flat interest rates range from 1.7-1.9x more when converted into the Effective Interest Rate equivalent. That is the true measure of your cost of financing.

Conclusion

When considering a loan product, it is always important to know if it is using the Reducing Balance Method of interest calculation or Flat Interest Rate method. And the best way to compare the true cost of the loan is to convert everything into the Effective Interest Rate equivalent. Make use of this Flat to Effective Interest Rate Converter.