Loans come in many different forms, such as student loans, mortgages, car loans and instalment plans. When paying back your loan, you will have to pay interest. Interest rates are both charged and quoted in different ways, which can impact how much the loan is actually costing you in its entirety. Get into the habit of looking beyond just the advertised interest rate!
Let us take a look at two different types of loans: loans with a flat interest rate and loans with a reducing balance. Each uses the stated interest rate differently!
For these loans, you are charged interest based on the original loan amount. Every month, you will pay a fixed monthly interest charge and a fixed amount to repay the principal, i.e. your original loan. Hence, your monthly payments are a fixed amount and will be constant throughout the loan period.
The advertised interest rate is known as the simple interest rate. It can often be deceiving, as consumers end up getting charged far more in interest than they expect. A common example of a flat rate loan is a car loan. Let’s run through an example:
* A nominal rate means this is the rate charged for 1 year. This value requires adjusting to your compounding period, which in this case, will be your instalment period of one month. Most rates you see are given as a nominal rate.
Monthly interest payments
= interest rate adjusted to monthly x original loan amount
= (0.035 x 1/12) x $2,000
= $5.83
Monthly principal repayment
= loan amount / total number of months
= $2,000 / (5*12)
= $33.33
Total monthly payments
= monthly interest payments + monthly principal repayments
= $5.83 + $33.33
= $39.16
Total payments over the life of the loan
= $2,350, of which $350 was for interest payments.
Photo by Christin Hume on Unsplash
Under this loan, you are charged interest based on your outstanding loan amount instead of the original. Like a flat rate loan, you are making a fixed loan repayment every month. Some will go towards paying the interest incurred and some is used to repay your original loan. Unlike a flat rate loan, the allocation between paying down the principal and interest varies.
As each month passes, your outstanding loan amount decreases (a process named monthly rest), so the interest incurred also decreases. This process is why more of your monthly payments are used to offset your original loan amount as time passes. Examples of this kind of loan, often named amortisation loans, include a mortgage or a home renovation loan.
Let’s run through the same example:
Note: A nominal rate means that this is the rate charged for 1 year. This value requires adjusting to your instalment repayment period of, in this case, one month. Most rates you see are given as a nominal rate.
Interest payment for the first month
= interest rate adjusted to monthly x outstanding loan amount
= (0.035 x 1/12) x $2,000
= $5.83
Principal repayment for the first month
= monthly payment - interest payment for the first month
= $36.38 - $5.83
= $30.55
Interest payment for the second month
= interest rate adjusted to monthly x outstanding loan amount
= (0.035 * 1/12) * ($2,000 - $30.55)
= $5.74
Principal repayment for the second month
= monthly payment - interest payment for the second month
= $36.38 - $5.74
= $30.64
Interest payment for the last month
= interest rate adjusted to monthly x outstanding loan amount
= (0.035 * 1/12) * ($36.28)
= 0.10
Principal repayment for the last month
= monthly payment - interest payment for the last month
= $36.38 - $0.10
= $36.28
This brings your outstanding loan amount to zero. As with the flat rate loan above, you will have paid off the entire loan when you make your last payment. The difference is that you will have only paid a total of $2,183 over the life of the loan, of which $183 was for interest payments. The interest paid is 47.7% lower than the $350 you would have paid if it was a flat rate loan!
FLAT RATE VS REDUCING BALANCE. COMPLETED ✅
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