Reducing Balance Method: What Exactly is it and Why it Saves You Money.

Sometimes, it takes a little help to achieve the dream we aspire to achieve. When considering a loan or credit line to reach that goal, it can be difficult to understand how interest rates are determined. To explain we will use a case study below:

Njoroge is window-shopping for a two-year business loan. There is a good investment opportunity that has arisen and he does not have all the funds needed to fulfill the opportunity. He is anxious about the rates he is going to get due to the currently high rate of interest environment. He first walks into the first microfinance and they give him a quote of 3.5% per month. He then approaches a second microfinance institution and much to his surprise, they give him a rate of 2.5% per month. Everyone he talks to tells him that is a good offer, as there are hardly any microfinance institutions offering that kind of rate in the current environment. It therefore becomes obvious what his preferred option is. A week later, he has quickly signed on the line and walked away with Ksh. 1 million.

A few weeks later, Njoroge’s wife is catching up on filling their financial records. At first glance, she notices that the disbursement letter he signed states that interest will be calculated on a ‘flat interest basis’. She finds it is strange because other loans they have taken in the past have always been on ‘reducing balance’. So what has Njoroge actually signed up for?

The most cost saving loans are calculated based on reducing balance. What this suggests is that interest is calculated and charged on a monthly basis only on the outstanding amount of the loan. From the monthly repayment, there are two elements. Principle is that the portion of the payment that reduces the outstanding balance of the loan. Interest is the cost you’re paying for having access to the cash. With the reducing balance loan, the monthly payment amount will remain the same, but the interest part of the payment will decrease as the loan is lowered by the amount credited to the principal on a monthly basis. As you come towards the end of the loan, you will find that the total interest payment is minimal.

In Njoroge’s situation, however, he will pay the same amount of interest throughout the duration of the loan. The interest will always be calculated based on the initial amount borrowed throughout the entire two years. He does not get the advantage of interest being calculated on only the outstanding loan amount or reduced balance of the loan. The impact of ongoing repayment of principle is not considered in the least. These sorts of loans tend to supply a more attractive rate of interest but can compute to be costlier. On the reducing balance method, he would have paid interest of Ksh. 494,500 over the two years. However, on the flat rate method he will end up paying Ksh. 600,000 in interest over the same period. Though it had been quoted at a way cheaper rate, the methodology utilized in interest calculation makes an enormous difference.

When Njoroge’s wife realized that they would have to pay Ksh. 105,500 more than they should have, if they had used a reducing balance rate, she squabbled with her husband for not making a wise decision. She also referenced a famous quotes from Archibald MacLeish that says “There is only one thing more painful than learning from experience and that is not learning from experience.’’ Njoroge and his wife came to a resolution that they will always borrow from a microfinance institution that offers the reducing balance rate method.

Understanding how a loan is calculated can be a tricky business, so it is important to take the time to clarify those calculations with your trusted financial advisor for clarifications. When choosing a loan, aside from ensuring the needs of the loan add up, always confirm you recognize how the interest is going to be calculated.

At Springboard Capital Limited, we offer our loans at a 3.5% p.m. reducing balance method, which is beneficial to all our customers since they have to pay less amount of interest as per the loan tenure. Find more information about our loan products here and get in touch with us through 0700 944 444.

Article by: Richard Mwangi, Marketing Officer, Springboard Capital Ltd, who is passionate about brand and marketing. He is a cross-functional team player, possesses strong project management skills, and self-motivated.

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