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Effective Interest Is: Definition, Formulas, and Calculations

Admin BFI
25 July 2023
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Effective Interest Is: Definition, Formulas, and Calculations

In loans or credit, there are various important terms that you should know, one of which is effective interest. Effective interest is a different interest rate calculation than flat interest.

BFI friends, let's get to know what effective interest is, in full in the following article.

 

1. Definition of Effective Interest

Effective interest is one type of interest that is used in the financial world, especially in terms of loans or credit. Effective interest is interest that is calculated based on the remaining principal of the loan that has not been paid so that interest will decrease as the remaining principal of the loan decreases.

Effective interest is different from flat interest, which is interest calculated based on the initial principal amount of the loan, so the interest remains the same throughout the life of the loan. Flat interest is usually used for consumer loans, such as motor vehicle loans or loans without collateral.

1.1 Factors Affecting Effective Interest

There are several factors that affect the amount of effective interest, including:

  • The principal amount of the loan, namely the amount of money borrowed by customers from financial institutions.
  • Interest rate per year, namely the percentage of interest set by the financial institution for the loan.
  • The term of the loan, namely the length of time given by the financial institution for the customer to pay off the loan.
  • Installment payment frequency, namely the number of times the customer pays installments in a year. Usually, the frequency of installment payments is monthly, quarterly, semiannual, or annually.

2. Effective Interest Formula

Quoted from the official website of the Financial Services Authority (OJK), effective interest is the interest rate that can be calculated using the following method.

Effective Interest = SP x i x (30/360)

Information:

SP = Principal balance of the previous month's loan

i = Principal interest rate per year

30 = Number of days in a month

360 = Number of days in a year

3. Effective Interest Calculation Simulation

To clarify how to calculate effective interest using the formula above, let's look at the following effective interest calculation simulation.

For example, Person A gets a loan principal from a financing company of IDR 300 million. From existing loans, Si A bears an effective interest of 10% per year with an agreement to repay the loan for 2 years (24 months). From this, the effective interest calculation can be obtained as follows.

3.1. Month Installment 1

Total installments: IDR 300 Million / 24 Months = IDR 12.5 Million

Interest calculation: IDR 300 Million x 10% x (30 Days/360 Days) = IDR 2.5 Million

From the results of these calculations, it is concluded that the 1st-month interest installment = IDR 12.5 million + IDR 2.5 million = IDR 15 million

Month Installment 2

Because Person A has paid installments in month 1 of Rp. 12.5 million, thus the principal balance to be paid is reduced to Rp. 287.5 million (Rp. 300 million - Rp. 12.5 million), in this way the calculation for the second month's installment is Rp. 287.5 million x 10% x (30 Days / 360 Days) = Rp. 2.4 million.

Based on the two calculations above, it can be concluded that the effective interest varies each month and will get smaller following the ongoing installment period.

4. The Difference Between Effective Interest and Flat Interest

bunga efektif

Image Source: Pexels/Gustavo Fring

Effective interest and flat interest have significant differences, both in terms of the method of calculation and in terms of advantages and disadvantages.

Here are some differences between effective interest and flat interest:

4.1 Effective Interest

4.1.1. Advantages

1. More Accurate

Effective interest calculates interest based on the remaining balance of the loan for each payment period, thus providing an accurate picture of the amount of interest to be paid.

2. Fairer

Borrowers benefit because the amount of interest paid will decrease as the loan balance decreases.

3. More Transparent

Borrowers can easily see the total amount of interest that must be paid throughout the loan period.

4.1.2 Disadvantages

1. Complicated Calculations

Calculation of effective interest is more complicated than flat interest, so it requires more careful calculations.

2. Higher

Effective interest is often higher than flat interest because the amount of interest is calculated based on the remaining balance which has decreased over time.

4.2.Flat Interest

4.2.1 Advantages

1. Simpler Calculations

The calculation of flat interest is simpler and easier to understand because the amount of interest is calculated based on the initial loan amount.

2. Easy to Budget

Borrowers can easily budget for interest payments because the amount is fixed throughout the loan term.

4.2.2 Disadvantages

1. Amount of Relatively Higher Interest

Flat interest does not take into account the decrease in the loan balance from the previous payment, so the amount of interest paid tends to be higher than the effective interest.

2. Less Profitable For Borrowers

Borrowers or debtors benefit less from paying interest at the beginning because the amount of interest is fixed throughout the term of the loan.

From the differences that exist between the two, it can be concluded that effective interest is preferred because it provides a more accurate picture of the amount of interest to be paid and is more profitable for the borrower.

Even so, flat interest is still widely chosen because the calculation is simpler and easier to implement. As borrowers, it is important for us to understand the type of interest applied to the loan and compare the total cost of the loan before making a decision.

Friend BFI, thus the discussion regarding Effective Interest Is: Definition, Formula, and the Difference with Flat Interest. Hopefully, this article can help you easily understand what flat flowers are. Be sure to consider many things carefully so that the loan you take doesn't interfere with your monthly cash flow.

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