Banks should be stopped from taking unfair advantage of borrowers with personal loans or fixed rate hire-purchase loans (of either the conventional or Islamic financing variety. )
These borrowers lose twice over because interest on the loans are calculated on a flat rate basis and rebates are calculated based on the Rule of 78.
The flat rate method charges interest on money which has already been repaid whilst the Rule of 78 penalizes those who repay early.
Calculating interest on loan
Under the flat rate basis, interest is calculated on the total principal. It does not take into consideration that after each repayment the borrower owes the company less each month. When interest is charged on the original principal, the poor borrower is made to pay interest on money that he has already repaid.
Take for example a 5 year personal loan for RM30,000 at an interest rate of 10% per annum.
When interest on the above loan is calculated on a flat rate basis, the total interest charged is RM15,000 (RM30,000 X 10% X 5 Years) and the monthly payment is RM750. Total cost of the loan comes up to RM45,000. (RM30,000 +RM15,000)
On the other hand if the reducing balance method is used, interest will be charged on the outstanding amount at the end of each month after the monthly instalment has been repaid.
Under the reducing balance method total interest charged works out to be RM8,244.68 and the monthly payment comes down to RM 637.41. Total cost of the loan is RM38,244.68.
It is easy to see why banks prefer the flat rate method of calculation as it enables them to make more profits. In this case they can make an extra profit of RM6,755.32 (RM45,000 – RM38,244.68)
Calculating rebate for early settlement
It is to the banks advantage to use the Rule of 78 to calculate the amount of rebate that has to be refunded in cases of early repayment of personal loans and hire-purchase loans.
The Rule of 78 works by apportions the total interest payable under a loan in accordance with an arithmetic formula. Under the formula the early instalments include a surprisingly larger interest components than the later ones.
For example, you choose to settle your 60 months loan after paying 30 instalments. Under the Rule of 78, at 30 months the interest paid so far has already reached RM11,188.55. At 30 months you are only half way through the loan but the interest you have already paid on it is 74.6 % of the total interest of RM15,000. This means that you get only a rebate or savings of only RM3,811.45 (RM15,000- RM 11,188.55) or 25.4% by paying off the loan early.
You would have expected to save RM7,500.00 as this half of the RM15,000.00 interest charged on the loan.
Because the Rule of 78 is unfair to borrowers, it has been abolished in the UK since 2005.
On the other hand if the reducing balance method is used, after 30 months the total interest that you have paid on the loan is RM5,979.99. That is a about half of the RM11,188.55 interest that you had paid under the Rule of 78.
Again the difference of RM5,208.56 (RM11,188.55 – RM5,979.99) is why the banks the flat rate interest calculation on top the use of Rule of 78. It gives the bank added profits on top the already unfair profits from the use of Rule of 78.
When the consumer takes out a personal or fixed rate hire-purchase loan, the bank overcharges him interest (via flat rate calculation) and then proceeds to penalize him should he repay the loan early (via Rule of 78). Thus this is a classic case of “heads I win, tails you lose” The borrowers loses either way.
It is time Bank Negara direct banks to use the reducing balance method of calculation for all types of loans and stop using the Rule of 78.
Press release, 26 November 2014