How to calculate interest on a loan?
Financial institutions use several common methods to calculate the loan interest, namely Reducing Balance (also known as Rest Method), Flat Rate and the Rule of 78. Different types of loans use different interest calculation methods, for example, Home Loans are using the Reducing Balance method, while Car Loans & Personal Loans are using the Flat Rate method, etc. In layman’s terms,
Interest is calculated based on the remaining principal balance after each loan installment. It means that the interest amount on the next billing will always be lower than the previous bill. This interest calculation method is usually applied to Home Loans.
Interest is calculated upfront based on the original loan amount. It means that the interest amount per bill is evenly distributed. This interest calculation method normally applied to Car Loans and Personal Loans.
Rule of 78
Interest is calculated based on a formula, where most of the interest is paid at the beginning of the loan. This means that most of the principal is paid towards the end of the loan, early settlement does not save much on the interest. Some financial institutions still use this interest calculation method on Car Loans and Hire Purchase Agreements.
All this depends on how the lender structures the loan product, for example, Bank A uses Flat Rate on their Personal Loan while Bank B uses Reducing Balance on their Personal Loan. Therefore, it is important to check with the financial institution to find out their loan interest calculation method.