Reducing Balance vs. Simple Interest Loans – Which is Better?

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Simple interest loans and reducing balance loans are the two most common loan products banks and other financial institutions offer. They use these methods to calculate interest on different types of loan products such as mortgages, car loans, personal loans, education loans and much more. Certain methods are best for certain products, which others not so much. There is a myriad of loan products offered with different interest rate calculation methods to fulfil your financial desires.

So, let’s explore these two common methods offered by banks and other financial institutions on loans:

Simple Interest Method

Simple interest rate is interest calculated on the full amount of the loan (principal) throughout its tenure without loan period without consideration for the monthly payments that are gradually reducing the loan amount. Therefore, the total amount paid is equal to the amount borrowed plus interest.

Hence, Interest = Principal x interest rate x number of years

For example, if you take a loan of Ksh 100,000 with a simple rate of interest of 10% per annum for 5 years, then you would pay back:

  • Ksh. 50,000 (Ksh. 100,000 x 10% x 5 Years) in interest by the end of the loan period.
  • The yearly interest payable is equal to Ksh. 10,000, while the principal repayment is Ksh. 20,000, which is Ksh. 30,000 per year or Ksh. 2,500 per month. Over the period, you would actually be paying Ksh. 150,000.
  • Therefore, in this example, the monthly equated monthly instalment of Ksh. 2,500 converts to an Effective Interest Rate of 17.27% p.a.

See the table below:

YearPrincipalPrincipal
Repayment
Interest
Payable
Equated Yearly
Payments
1100,00020,00010,00030,000
2100,00020,00010,00030,000
3100,00020,00010,00030,000
4100,00020,00010,00030,000
5100,00020,00010,00030,000
TOTAL100,00050,000150,000

Who Benefits from A Simple Interest Loan?

Simple interest loans are quite unpopular amongst borrowers because even though you gradually pay down your loan, your interest does not decrease. The interest will always be calculated on the initial amount borrowed throughout the entire loan period.

What Type of Loans Use Simple Interest?

Loan products that use simple interest, typically have attractive interest rates but when you put pen to paper and do the math, they tend to be more expensive. This method is particularly used by banks and other institutions to calculate interest payable on personal loans, consumer loans and car loans.

Learn More: Snowball vs Avalanche: The Best Way to Pay Off Debt

Reducing Balance Method

Reducing balance is interest calculated every payment period on the outstanding loan amount. Thus the equated monthly instalments include interest payable for the outstanding loan amount in addition to the principal payment.

Hence, interest payable = interest rate x outstanding loan amount

For example, if you take a loan of Ksh. 100,000 with a reducing rate of interest of 10% p.a. for 5 years, then your repayment will be as follows:

YearOutstanding
Balance
Principal
Repayment
Interest
Payment
Total Payment
1100,00020,00010,00030,000
280,00020,0008,00028,000
360,00020,0006,00026,000
440,00020,0004,00024,000
520,00020,0002,00022,000
TOTAL100,00030,000130,000

Who Benefits from A Reducing Balance Loan?

When you choose loan products with the reducing balance method, it means that you will pay less interest on your loan. However, many banks do not offer this. Almost all credit unions in Kenya offer loan products that utilize the reducing balance method. Therefore, as a member use their loan options to meet your own needs and payment ability.

What Type of Loans Use Reducing Balance?

This method is particularly used to calculate the interest payable for mortgages, overdraft facilities and credit cards. However, loans offered by credit unions also use this method to calculate interest.

Learn more: All You Need to Know About Credit Card Interest Rates

Which is better?

In financial terms, the reducing rate method is better than the simple interest rate method because it is cheaper in the long run. Though it is much harder to compute and equated monthly/yearly payments are much higher, the true cost of a loan under this method is much lower.

At the end of the day…

The method used to calculate interest makes a huge difference in how much you pay on a loan. Therefore, when choosing a loan product ensure you the true cost of the loan. Take the time to clarify those calculations with your trusted financial advisor. Understanding the basics will help you make better-informed decisions that will lead to greater savings and open even more doors to greater opportunities.

And while on it, watch out for those extremely attractive interest rates – read the fine print. There is always a catch!

Happy Building!


Image credits: Top by Nataliya Vaitkevich from Pexels

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Irene Makanga
Irene has an MBA in Finance and is an avid businesswoman, passionate about financial literacy.

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