Choosing Between Loan Interest Rates – Reducing Balance Or Flat Rate Method

Choosing Between Loan Interest Rates – Reducing Balance Or Flat Rate Method

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UNDERSTANDING LOAN INTEREST RATE CALCULATIONS

When getting a loan, one of the most important things to look out for is the interest rate because this is what determines how much you pay back at the end of the day, however, a lot of people still get it wrong when picking between loan offers because they do not understand it. Lets take the case of Wale for example.

Wale’s rent is due and he needs a loan quickly to keep his landlord from kicking him out but wale wants a loan that will be favourable to his salary. After searching and researching, he has two loan offers on his hands, N600,000 each with same tenure (loan period) and requirements but there was a big difference, Bank A offered him the loan at 4% flat interest rate on a monthly basis while Bank B offered 6% monthly on a reducing balance interest rate. It was an easy decision for wale, Bank A he thought, this would definitely guarantee he pays back the lesser amount on the N600,000. To Wale, he was getting the best deal possible.

In reality however, with Bank A‘s offer Wale will eventually pay back about N888,000 while he would have had to paid back about N860,000 with Bank B‘s offer but  Wale fell victim to not understanding the fine print and many loan seekers are still falling victim to this very technicality. You’re in luck because in this article, your ignorance will be put to the sword once and for all.

WHAT IS A FLAT INTEREST RATE

When using a flat rate method for calculating interest on a loan, the interest is paid on the amount borrowed monthly/yearly/quarterly (as the case may be) without taking into consideration repayments being made. In other words, the principal remains constant throughout the loan duration.

In the case of Wale, to repay N600,000 in 12 months, there would have to be deposits of N50,000 for each month (without considering interest). A 4% flat interest rate on N600,000 would mean he pays an interest of N24,000 monthly (4% of N600,000) and N288,000 totally in interest. His total monthly repayment will then be N74,000 (N50,000 + N24,000). Sadly, most loan seekers are only aware of this type of interest calculation.

WHAT IS A REDUCING BALANCE INTEREST RATE

On the hand, a reducing balance interest rate method takes into consideration your loan repayments. What does this mean exactly you may ask, it simply means the interest is calculated on the balance after each repayment and not on the amount borrowed. The principal reduces as repayments are made.

In Wales case of 6% monthly on a reducing balance for N600,000, the interest he will pay for the first month will be 6% of N600,000 which is N36,000. The second month’s interest will not be calculated on N600,000 but will ideally be calculated on N550,000 and the third month calculated on N500,000 (the balance keeps reducing  by N50,000 because that is what is needed to repay N600,000 12 times).

His total first month repayment would be N86,000 (N50,000 + N36,000) and the subsequent monthly installments keep reducing as the loan balance reduces. This definitely seems very complicated and loan seekers will find it difficult to keep up if they have to pay a different amount every month and that is where an EMI (Equal Monthly Installments) formula comes in. A reducing balance EMI formula is used to calculate loans on a reducing balance method so as to achieve equal monthly installments. There is no universal reducing balance EMI formula (Every financial institution has theirs) thus you usually have to ascertain your monthly repayment from the institution before you collect a loan.

In Creditville Limited, we have a unique reducing balance loan calculator that is extremely customer friendly making us the best when it comes to low interest loans available in Nigeria. If Wale had taken a N600,000 loan for 12 months at 6% on a reducing balance from Creditville, his monthly installment would have been N71,522.22 which is much less than the N74,000 he would pay for the same amount at a 4% flat interest rate.

In conclusion, interest rates are a delicate subject that every loan seeker should pay attention to and the fine print should be read dutifully. On average, loans on a reducing balance are better than those calculated on a flat rate because the reducing balance method is the true reflection of how the loan will be serviced.

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