How do Banks Calculate Interest Rates?

How do Banks Calculate Interest Rates?

May 10, 2018 by AmwalCom

Over time, borrowing a loan from a bank has grown easier. In the past, it used to be a long tedious process that required a pile of documentation and a series of approvals. Nowadays, people can request a loan from any bank and receive it by the next day. The principle of loaning is rather appealing; borrowing a decent amount of money and paying it off gradually is like a dream come true, up until the word "interest" comes into play.

What is interest and how do banks determine its percentage?  

Investopedia defines interest as ‘the charge for the privilege of borrowing money’. To put it simply, interest is the bank’s annual fees for lending you the money.

On what basis is the interest rate calculated?

To understand the mathematics of the interest rate on your loan, first you have to learn about the two main types of interest: flat interest and reducing interest.

1.      Flat interest rate means a fixed charge paid on the original amount of the loan, also called the principal. This is usually the case with car loans/finance.

Let’s say that you decided to borrow a loan of 50K JOD from a bank. The interest rate this bank offers is a flat interest rate of 10% to be paid on a yearly basis for five years. This means that every year, you will be paying an extra amount of 5K JOD equally distributed over installment payments.     
Given that the loan period is five years (60 months), the monthly payment for the loan in the previous example would be 75,000 JOD/60 months = 1,250 JOD The question is: how much of the monthly payment (1,250 JOD) goes for interest? To answer this question, you ca use the equation below:  

Interest payable per instalment =
(Original Loan Amount x Number Of Years x Interest Rate Per Annum) ÷ Number Of Instalments  

The monthly interest paid = (50,000 JOD * 5 Years * 10%) / 60                                                                                                                                                                                  =417 JOD (833 JOD is paid for the loan)
Not a big fan of numbers? Try out our Loan Calculator by visiting the type of loan you’re interested in.  

Reducing interest rate: this interest is based on the amount of outstanding payment that is remaining with the passing of every year, i.e. the interest rate decreases after each year (except in cases with default in payment). Taking the same example, a 10% reducing annual rate on the 50K dinar loan planned to be paid over a period of five years is as follows:

First year: the interest to be paid over the year sums up to 5K JOD.
Second year: the interest is 10% of the remaining outstanding amount. Since 10K JOD of the loan is paid, 40K are left. Therefore, the second year’s interest rate amounts to 4K JOD.
Third year: By the 3rd year, 30K JOD are left è 10% * 30K = 3K JOD of interest is applied.
By the last year of payment, you will have to pay 1K JOD of interest instead of 5K JOD as in the case of flat rate.  

Finally, you should be careful when taking a loan, whether with a flat or reducing interest rate. Read the terms and conditions carefully and cross-check the items more than once. There isn’t a standardized loaning system for all banks. Therefore, check with a consultant and ask lots of questions if needed.

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