There are two main ways in which a lender can calculate interest charges:
Flat rate
With a flat interest rate, interest is charged throughout the term on the full, original amount of the loan, and ignores the fact that regular payments are being made to reduce the capital outstanding. The flat rate method is used to calculate interest charges for the vast majority of motor finance products.
The effect of this arrangement is that the customer gains no benefit from paying off some of the capital each month. The true rate (the APR) is far higher than the quoted rate. In the example below, based purely on the interest paid without taking into account any other financing costs, the APR would be approximately 7.8%. If there was a £100 documentation fee paid with the first repayment, and a £100 option-to-purchase fee with the final repayment, the APR would increase to 8.9%.
Example:
A customer borrows £10,800 over 3 years at 4% per annum (flat rate) and pays the loan back in 36 regular monthly payments.
- Capital borrowed £10,800
- Total interest 4% pa x 3 years = 12%* £1,296
- Total capital + interest £12,096
- 36 monthly payments £336
- Total interest is charged on the original capital borrowed.
Declining balance
With a declining balance calculation, interest is charged each month on the outstanding balance rather than the initial loan.
The borrower makes a fixed payment each month, and with each payment some capital is repaid, while interest is based on the reduced capital.
This is sometimes referred to as an ‘APR loan’, because it reflects the true interest rate paid throughout the term. Declining balance interest is not commonly used with motor finance products, it is the standard way of charging interest for credit cards and store cards.
Example:
Using our previous example with a nominal interest rate of 4%, we can see how the declining balance method works in the borrower’s favour:
- Capital borrowed £10,800
- Total interest 4% pa x 3 years* £691
- Total capital + interest £11,491
- 36 monthly payments £319
- Interest is charged on the capital outstanding at each payment date.