As an ex-banker and still in the financial services business, I have had to explain this core banking concept to customers and clients on countless occasions. Most of them can’t just have enough of the explanations as they keep wanting to know more about the charges and how it is applied.
I have therefore put some thoughts to paper and my understanding of the Interest Rate as used in the banking industry is clearly expressed in this article. What more? I have also made attempt to simplify how interest rates are calculated, so my readers can have a clearer understanding of the meaning of interest rates
What is Interest Rate?
“Interest rate according to Investopedia, “Is the amount charged, expressed as a percentage of principal, by a lender to a borrower for the use of assets. Interest rates are typically noted on an annual basis, known as the annual percentage rate (APR). The assets borrowed could include, cash, consumer goods, large assets, such as a vehicle or building. Interest is essentially a rental, or leasing charge to the borrower, for the asset’s use. In the case of a large asset, like a vehicle or building, the interest rate is sometimes known as the “lease rate”. When the borrower is a low-risk party, they will usually be charged a low interest rate; if the borrower is considered high risk, the interest rate that they are charged will be higher.” Investopedia
The Wikipedia defines interest rate as “The amount of interest due per period, as a proportion of the amount lent, deposited or borrowed (called the principal sum). The total interest on an amount lent or borrowed depends on the principal sum, the interest rate, the compounding frequency, and the length of time over which it is lent, deposited or borrowed.”
“it is defined as the proportion of an amount loaned which a lender charges as interest to the borrower, normally expressed as an annual percentage. It is the rate a bank or other lender charges to borrow its money, or the rate a bank pays its savers for keeping money in an account.”
Interest rate is the rate of interest payable on amount borrowed. It is the cost of fund to the borrower and the rent the borrower pays to the lender for the use of lender’s funds.
It is however, very important for the borrower to know and understand the interest patterns on his loan and agree with the lender on a suitable interest pattern before he signs the loan offer. Another important part of the loan agreement the borrower must understand and agree to before executing the offer is the repayment pattern. The pattern can be monthly, quarterly, biannually, annually or as agreed base on the borrowers cash flow and repayment ability.
Methods of calculating Interest Rates on Loans
There are the two major methods of calculating interest on loans. The straight line method and the reducing or declining balance method.
The straight line method
The Straight Line Method requires that the borrower pays and equal amount on interest at intervals over the life of the loan. This type of loan does not need to have a typical amortization schedule as can be manually calculated. All you need is the principal and the interest rate on the loan. The principal is divided over the repayment period and thus the interest and an equal amount is paid at agreed interval throughout the loan tenor.
For example, a loan of N10,000,000 payable monthly over a 3 years period at an interest rate of 15 percent per annum.
15% of 10,000,000 will amount to 1,500,000 interest payable on the loan per annum together with principal. Thus the lender will pay principal of (10,000,000/36) = 277.777.78 monthly and interest of (1,500,000/12) = 125,000 monthly. The monthly amount payable on the loan is (277,777.78+125,000) = 402,777.78.
The amount payable of the same loan quarterly is 1,208,333.34 being (833,333.34+375,000) and biannually 2,416,666.68 and 4,833,333.36 annually at 15% interest rate for straight line method.
Reducing or Declining Balance Method
The Reducing Or Declining Balance Method calculates interest based on the outstanding principal to be paid on the loan. Monthly repayment is calculated in such a way that the interest on the loan is higher at the initial repayment period and reduces gradually base on the outstanding principal while loan principal repayment is lower at the initial repayment period and increases gradually to arrive at an equal repayment amount (EMI) at regular intervals often monthly.
The EMI is calculated using this formula EMI = i*P / [1- (1+i)^-n]
Where, P = loan amount (principal)
r = rate of interest per year/per month
n = term of the loan in periods
l = length of a period (Fraction of a year, i.e.,
1/12 = 1 month, 1/52 = Week;If Interest calculation period is Daily then 7/365 = Week)
i = Interest rate per period (r*l)
Note: Interest = Principal balance*i
Using the same example above: A loan of N10,000,000 payable monthly over a 3 years period at an interest rate of 15 percent per annum.
r = 15/100,
l = 1/12,
n = 36,
i = 15/100 * 1/12 = 0.0125
EMI = 0.0125 * 10,000,000 / [1-(1+0.0125)^-36]
EMI = 346,653.29 monthly, quarterly = 1,039,959.87, biannually = 2,079,919.74, annually 4,159,839.48
It is important to note that most Commercial Banks in Nigerian adopt the Declining Balance Method for loan repayment while most Micro Finance Bank used the Straight Line Method for calculating interest on loan repayment