Interest Calculation Methods in Loans
  • 18 Jan 2022
  • 7 Minutes To Read
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Interest Calculation Methods in Loans

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Interest on loans is accrued on a daily basis, which allows you to charge your clients only for the days they used the loan amount.

For example, if a client pays back the loan amount before the due date, Mambu will display the exact interest amount that the client owes at that moment. Also, when a repayment is late, interest will keep accumulating each day.

The only calculation method in which interest is not accrued in Mambu is Fixed Flat. When using this method, the interest always reflects the amount that would be due on the due date, regardless of the actual payment date.

There are three different interest calculation methods you can choose from for your loan product:

  • Fixed Flat
  • Declining Balance
  • Declining Balance (Equal Installments)

When creating a new loan product, you must choose one of these methods for that product and all the accounts created under it.

Below you can find an example of how the repayment schedules would look for each of the interest calculation methods. The loan details for every example below are:

  • Loan Amount: USD1 000
  • Interest Rate: 10%
  • Number of installments: 4
  • Monthly repayments
  • Interest Rate Frequency: Monthly
  • Disbursement Date: 2011/1/23
  • Days in year: 365 days

Fixed Flat

The Fixed Flat calculation method is the only method for which interest is not accrued over time. All interest and principal become due immediately upon disbursement regardless of the first repayment date.

The interest due depends only on the interest rate, principal amount and time between repayments.
Schedule Preview for Fixed Flat Interest Calculation Method


Declining Balance

The Declining Balance method reflects the actual cost of the loan more accurately than the Fixed Flat method, as the interest is calculated on the outstanding balance.

The client only pays interest on the actual amount they still owe and not on the total amount (as is the case with the Fixed Flat method).

In this case, as the client starts making repayments, the interest due keeps decreasing over the duration of the loan.

Schedule Preview for Declining Balance Interest Calculation Method.


Declining Balance (Equal Installments)

The Declining Balance (Equal Installments) method is similar to the Declining Balance method in that the interest is calculated on the outstanding principal amount. However the difference between these two calculation methods is that for the Declining Balance (Equal Installments) method, the client pays equal installments for the duration of the loan. This is achieved by increasing the amount of principal being repayed as the interest decreases, adding up to the same fixed amount for each installment.

Schedule Preview for Declining Balance (Equal Instalments) Interest Calculation Method

Non-equal installments due to rounding and first repayment date

In some situations, one of the installments may be slightly different from the others.

This can occur when the time from disbursement until the first repayment date is longer than the time between each installment. In this case, there will be more interest accrued and less principal in the first installment, and the remaining principal is added to the last or to the first installment – as defined in the loan product settings.


Accrue Late Interest

Normally, businesses have the right to charge interest on late payments. However, you may want to disable this option if, for example, you want to create a flexible product which rewards clients for paying on time rather than penalises them for paying late.

Accrue Late Interest is enabled by default for all kinds of Dynamic Term Loans.

However, you can disable it in order not to accrue and apply late interest but only if the Declining Balance (Equal Installments) interest calculation method is chosen. For all the other interest calculation methods, interest will be accrued by default and you don't have the option to change that.

The possibility to disable Accrue Late Interest is available for any Pre-Payment Allocation method as well as for all payment methods (Standard and Balloon).

The feature is available via API 2.0 and Mambu UI.

To disable the Accrue Late Interest checkbox in the Mambu UI, follow these steps (click to expand):

Under Product Type , select Dynamic Term Loan. Select the Payments Method
In the Interest Rate section, set the Interest Calculation Method to Declining Balance (Equal Installments). Select the Interest Calculation Method
In the Repayment Scheduling section, ensure that the Payments Method is set to Standard Payments. Select the Payments Method
In the Repayment Collection section, set the Pre-Payment Allocation method to On Upcoming Pending Installment Only. This uncovers the options for Pre-Payment Recalculation methods in the same section. Pre-Payment Recalculation
Set the Pre-Payment Recalculation method to Reduce Number of Installments. This uncovers the Accrue Late Interest checkbox in the Interest Rate section. Choose the Pre-Payment Recalculation method

The Accrue Late Interest checkbox


Interest Rate Source (Fixed or Indexed)

You can set up two types of interest rate sources, via the Interest Rate Source setting of a loan product:

  • Fixed: a fixed interest rate source, which is used for the the entire lifetime of the loan.
  • Indexed: the interest rate source is tied to a specific benchmark (determined by an external entity—such as the government) with rate changes based on the movement of the benchmark. In this case, loans will need to be updated to reflect the new interest rate whenever it changes.
Click to see where to set the Index Rate Source option for loan products. Select the Index Rate Source option

Please Note
Index rates are defined under Administration > Financial Setup > Rates, for more information, see Customizing Index Rates. They can only be applied to non-Flat interest calculation methods, since, for Fixed term with Flat Interest calculation products, the interest amounts are fixed from the beginning and cannot change.

The frequency at which the interest rate should be reviewed is determined when creating a product and can be set on a daily, weekly or monthly basis. If there is a new interest rate when the review is made, then all loans using that source as an Index Interest Rate will be updated.

Please Note

Interest rate changes will take effect immediately on the account as per the scheduled review frequency date or period as follows:
For a standard loan with both principal and interest: the upcoming installment due amount will not be changed (this will be done by adjusting the principal component of that installment).
For an interest only loan: the upcoming installment due amount will be changed right away as there will not be any principal component available to adjust the installment amount.

Example

Consider a loan with the following terms:

  • Loan Amount: USD1 000
  • Interest: 5% (index) + 2% (spread)
  • Monthly Installments
  • Disbursal date: 2011/12/13
  • Interest Frequency Review: Monthly

Now suppose that on January 1, the Central Bank keeps the Index rate at 5% and on February 1 increases it to 6%. The change will affect the loan's repayment schedule, according to the frequency review (in this case, the interest rate will change starting from 2012/03/13, one month from the review):

  • First installment on 2012/01/13: Interest = 5% Index + 2% Spread = 7% and the total interest due will not be changed.
  • Second installment on 2012/02/13: Interest = 5% Index + 2% Spread = 7% and total interest due will not be changed.
  • Third Installment on 2012/03/13: Interest = 6% Index + 2% Spread = 8% and total interest due will be changed (in case of equal installments, a new PMT will be generated, based on the new interest rate).
  • All the following installments will use Interest = 6% Index + 2% Spread = 8%.

Index Rate Constraints
You can apply a floor (min) or ceiling (max) to index interest rates as well. This means the combined index and spread cannot be less than or more than a predefined value. These limitations can be defined as part of the loan product configuration, and they will apply to all accounts based on this loan product. In addition, you can set a default for the interest rate.

Click to see where to set the Interest Rate Default, Floor and Ceiling for loan products. Select the Interest Rate Default, Floor and Ceiling

Example
Assume the floor rate is 10% and the ceiling rate is 20%.

Index Interest Rate Spread Calculated Rate Actual Rate
10 5 15 15
10 17 37 20
5 3 8 10

Days in Year

You can choose from three different ways to accrue interest on a loan:

  • Actual 365/Fixed: calculates the interest daily by counting the number of days in the calendar and using a fixed 365-day year length.
  • Actual/360: also computes the interest daily by counting the number of days in the calendar, but using a fixed 360-day year length.
  • 30E/360: counts the days from the calendar, but also introduces some changes on the months with 31 and 28 days.

Particulars of the 30E/360 method
When using this method, months that have 31 days will be considered to have 30 days. This implies that the number of accrued interest days will be the same on the 31st of that month as on the 30th.

The last day of February is treated as the 30th day of the month.

Furthermore, the 30E/360 days in year method will compute the interest knowing that there is a maximum of 360 interest days in that year. So for instance, if a loan account has repayments paid yearly, the interest will be calculated for 360 days, instead of the actual number of days in the calendar.

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