Flat interest rate and reducing balance rate
There are generally two types of interest rates – a flat interest rate (not to be confused with a fixed interest rate) and a reducing balance interest rate.
Flat interest rate
A flat interest rate is calculated based on the original amount you borrow (or principal).
For example, if you take a 5-year loan for RM1,000 at a flat interest rate of 4% per annum, you will be paying an interest of RM40 (i.e. 4% of RM1,000) every year for 5 years. In total, you will have paid RM200 in interest payments.
As a result, the total interest you need to pay remains the same no matter how much of the principal you repay.
Your EIR here is 7.42% (compared to the given flat interest rate of 4%).
This interest rate method is used for personal loans and vehicle/hire purchase loans.
Reducing balance interest rate
A reducing balance interest rate, on the other hand, is calculated based on your outstanding or leftover loan balance, which is the amount you originally borrowed (the principal) minus the amount you’ve already paid off.
For example, you take a 5-year loan for RM1,000 at a reducing balance interest rate of 4% per annum and make monthly payments. You’ll be paying off a bit of your principal each month, so the amount of interest you pay will also go down. In total (after the 5 years), you’ll have paid RM105 in interest payments.
Notice how this RM105 is about half of the RM200 interest for a flat interest rate loan of 4% per annum.
Your EIR here is 4% (same as the given reducing balance rate of 4%).
This interest rate method is most commonly used for home loans.