If you decide you want to take out a loan or credit, make sure you know the difference between effective and flat interest. Because the interest rate calculations are definitely different and affect the value of the monthly installments that you have to pay.
By knowing the difference in interest rate calculations, you can plan your finances well later. Apart from that, the difference between effective and flat interest can be seen from the requirements, advantages, disadvantages, use and transparency.
To make it easier to understand, let's just look at the complete review below.
1. Definition of Effective and Flat Interest
The interest rate, aka interest, is a calculation of the percentage of costs that you must pay after obtaining a loan from the owner of the capital. Usually, the calculation is calculated annually, but can also be calculated for a loan period of less than one year.
This means that if you are a capital owner and provide a loan through a financial institution, you can earn interest in accordance with applicable regulations.
So, to better understand the difference between effective and flat interest, you can first read the following definition.
1.1 Effective Interest
Effective interest is a type of interest rate that changes every time you make a payment. From time to time, the interest rate you have to pay will decrease based on the remaining principal amount of the loan.
So, when you pay the first installment with high interest, the second installment will be smaller than the first. Likewise, the third installment is more downhill than the second and so on.
If you compare the amount of interest paid, the value will be smaller than the flat interest system.
1.2 Flat Interest
Flat interest is an interest rate calculation system whose nominal value refers to the principal amount of the initial debt. This interest system has its own advantages because the calculations are simple and easy. If you take out credit or a loan with flat interest, you must pay the same nominal interest every month.
Therefore, you can know the amount of interest that must be paid from the start. So, you can better prepare your finances to pay these interest rates.
Also Read: 7 Ways to Manage Personal Finances Smartly and Accurately
2. Difference Between Effective and Flat Interest
So, what is the difference between effective and flat interest? Instead of getting more confused, just check the differences below.
2.1 Usage
You can find the first difference between effective and flat interest in terms of their use. The effective interest system is used for long-term loans with large nominal amounts. For example, investment credit and KPR.
Meanwhile, flat interest is often used for short-term loans, such as KTA (Unsecured Credit), electronic gadgets and KKB (Motor Vehicle Credit).
2.2 Interest Rates
The calculation of effective and flat interest rates is also different. Effective interest is calculated based on the remaining principal debt so that the interest rate and principal installments each month will be different, even though the amount of the installments each month remains the same.
Meanwhile, the flat interest amount will be calculated based on the term or loan tenor. Usually, the nominal flat interest rate is determined from the start of the credit application.
2.3 Advantages
You can see the difference between effective and flat interest in terms of profits. Both do have various advantages, such as:
2.3.1 Effective Interest Profit
There are several benefits of effective interest that you should know, namely:
2.3.1.1 More Accurate Interest Amount
You need to know that effective interest is a combination of flat and floating interest so that the nominal effective interest is said to be the most accurate according to the economic conditions at the time the interest was set.
Apart from having a high level of accuracy, the effective interest method is known to be the fairest for both parties, namely the lending institution and the borrower.
2.3.1.2 Suitable for Long-Term Installments
Of the many types of interest rates, the effective interest method is said to be the most suitable for long-term installments, such as mortgages or car loans. This is because car and mortgage installments tend to have a larger nominal value, so reducing interest every month will provide relief to borrowers.
2.3.1.3 Installment payments get lighter over time
Another advantage of effective interest is that the longer you pay the installments, the lower the interest rate paid will be. Of course, this is different from flat interest rates which have high figures from the start or floating interest rates which are getting bigger day by day.
Therefore, when you choose an effective interest method, every time you make an installment payment, the interest rate you have to pay will become smaller every month.
2.3.2 Flat Interest Benefits
Apart from effective interest, the flat interest method also has its own advantages, including:
2.3.2.1 The nominal interest is the same every month
The nominal interest you have to pay every month is the same and will not change. So, before deciding to get credit with a flat interest system, you must first confirm the amount of the monthly installments.
2.3.2.2 Simple Calculations
The method for calculating flat interest is quite simple, namely it is calculated from the initial loan principal, then divided evenly over the loan term. Of course, this makes it easier for you to understand and calculate the total loan costs as a whole. So, you can more easily organize and manage your finances for future payments.
2.3.2.3 Low Risk
The next advantage of flat interest is that it has lower risk than other types of interest. You don't need to worry about the interest rate benchmark which changes frequently. The thing is, the nominal interest is determined at the start, so it won't change every month.
2.3.2.4 Suitable for People on a Fixed Income
As previously explained, the flat interest system allows you to know the nominal interest and installments that must be paid in advance, so the flat interest rate method is suitable for those of you who have a fixed income. With these benefits, you can manage your finances appropriately, whether it's paying for credit or daily needs.
2.3.2.5 Suitable for Short and Medium Term Loans
The flat interest method is suitable for short and medium term loans. You can find out the nominal interest on the initial loan without any changes until you have successfully paid off the installments, so it is easier for you to prepare good financial planning later.
2.4 Weaknesses
Not only do they have advantages, effective and flat interest also have a number of disadvantages that you should be aware of, including:
2.4.1 Weaknesses of Effective Interest
Here are some disadvantages of effective interest that you should pay attention to, namely:
2.4.1.1 Amount of Interest is Larger at the Beginning
Although the effective interest rate payments decrease over time, you will have to pay more interest at the beginning of the loan.
Maybe for some customers this is not a problem. However, the high nominal interest at the beginning means borrowers have to allocate more funds when starting installments.
Therefore, you have to save and prepare a larger budget before deciding to take out credit with an effective interest system.
2.4.1.2 The calculation method is complicated
In fact, the effective interest calculation method is more complicated than the flat interest system, you know. Because, the basis for calculating this interest rate is the nominal installment of the last payment. In fact, to calculate effective interest you need a calculator so that the results are not wrong.
The calculation method will be explained at the end, so make sure you read until the end.
2.4.1.3 Amounts of interest are often not round
The final weakness of effective interest is that the nominal value of the interest rate is often not round. You will find payment numbers in fractions of thousands to hundreds of rupiah.
Therefore, to make the payment process easier, the recipient of the payment often suggests rounding up the nominal amount. For example, the installments and interest rate that must be paid total IDR 793,998, so it will be rounded up to IDR 794,000.
2.4.2 Disadvantages of Flat Interest
After knowing the weaknesses of effective interest rates, you also need to know the weaknesses of flat interest, namely:
2.4.2.1 Higher Installment Value
The disadvantage of the first flat interest is that you will get a larger installment value. This is because the interest calculation is based on the initial loan amount. So, the interest rate will remain the same until the last installment.
2.4.2.2 Not profitable if paid off quickly
Even if you want to pay off ahead of schedule, the amount of interest and total installments paid remain the same. There is no bonus reduction based on the remaining loan, you must pay as written from the start.
2.4.2.3 Not Taking into Account the Remaining Loan Principal
Lastly, the weakness of the flat interest rate is that it does not take into account the remaining principal on the loan. Therefore, this interest method is not suitable for long-term loans because it will increase the interest rate.
In fact, when interest rates are decreasing, you still pay the same nominal interest without any changes.
2.5 Requirements
You can then find out the difference between effective and flat interest in terms of requirements. Because flat interest is used for a short period of time, the requirements are quite easy. This easy process will benefit you, especially if you have a weak credit history.
Meanwhile effective interest is more complicated, although not as difficult as you might imagine. The problem is, the effective interest rate is used for long-term credit so it requires a number of more detailed information and documents. Even so, you can still apply for credit using the flat interest method, especially if your credit history is good and smooth.
Also Read: Bad Credit; Definition, Causes, and How to Overcome It
2.6 Transparency
Flat interest generally has clear transparency and is easy to understand because the amount of interest you have to pay does not change. So, it is easier for you to make financial calculations and budgets every month.
Meanwhile, effective interest tends to lack transparency because the nominal interest rate changes. However, effective interest is more accurate in reflecting costs and refunds, because it takes into account changes in the balance.
Although there are several differences between effective and flat interest, you can choose one of the interest rates according to your needs and abilities. Make sure to always consider carefully before deciding to take an effective or flat interest rate, OK? This is one of the factors for you to be able to pay off the installments until the end without any problems.
3. How to Calculate Effective Interest and Flat Interest
For those of you who already understand the difference between effective and flat interest, now is the time to find out how to calculate these two interest rates. Of course, effective interest and flat interest have different formulas and calculation methods.
So, for those of you who are curious and want to try calculating effective or flat interest, you can follow the methods below.
3.1 Effective Interest
Before starting to calculate effective interest, you must first know the formula, namely:
3.1.1 Effective Interest Formula
You can calculate the effective interest rate using the following formula:
Effective interest = SP x I x (30/360)
It means:
1. SP = principal loan balance from the previous month
2. i = interest amount per year (in percentage)
3. 30/360 = proportion of days in one month to one year.
3.1.2 How to Calculate Effective Interest
You can see how to calculate effective interest through the following example.
A makes a loan to a financial institution with a principal value of IDR 500 million. Of the loan amount, A is subject to interest of 15% per year with an agreed loan term of 5 years or 60 months.
By using the effective interest formula, the results are obtained:
1st month installment payment:
Installment amount: IDR 500 million / 60 months = IDR 8.33 million
Effective interest calculation: IDR 500 million x 15% x (30 days/360 days) = IDR 6,250,000
From this calculation, it is concluded that the first month's installment that you must pay is: IDR 8.33 million + IDR 6,250,000 = IDR 14,580,000
2nd month installment payment:
Because A has already paid the first month's installment of IDR 8.33 million, the principal balance paid has been reduced to IDR 491,670,000 (IDR 500 million - IDR 8.33 million).
So, the calculation for the second effective interest is IDR 491,670,000 x 15% x (30/360 days) = IDR 6,145,875.
From the example above, you can see that the effective interest rate will decrease each month along with the payment period where the principal amount paid will decrease.
3.2 Flat Interest
After knowing the calculation of effective interest rates, next you have to know how to calculate flat interest. The interest calculation process is quite easy, you only need to follow the formula provided below.
3.2.1 Flat Interest Formula
There are three flat interest formulas that you must note and remember, namely:
1. Principal installments per month = Principal Loan / Time
2. Amount of interest per month = Principal Loan x Interest / Time
3. Total that must be paid per month = Principal Installments + Interest Installments
3.2.2 How to Calculate Flat Interest
The following is an example of how to calculate flat interest that you can follow:
X borrowed money from a finance company worth IDR 25 million to buy a motorbike on credit. The finance company applies a flat interest method of 15% per year. So, how many installments does X have to pay every month?
Here's how to calculate it:
Loan principal: IDR 25 million
Flat interest: 15%
Loan length: 1 year (12 months)
The first step, you must first know how much the principal installments are per month, namely:
IDR 25 million / 12 months = IDR 2,083,000
Next, determine how much interest must be paid per month using the formula provided previously, namely:
IDR 25 million x 15% / 12 months = IDR 312,500
So, the total bill you have to pay every month to pay off the loan is:
IDR 2,083,000 + IDR 312,500 = IDR 2,395,500.
How, it's very easy, right? By knowing how to calculate effective and flat interest, you can estimate how much loan will have to be paid later. You can also find out which credit interest rate to choose if you want to take out a long or short term loan.
That is the information about the difference between effective and flat interest which you can read in full. Now, you are no longer confused about the differences between the two, right?
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