Interest Calculation Methods in Loans
- Updated on 15 Apr 2019
- 6 minutes to read
The interest on loans is accrued on a daily basis, which allows you to charge your clients only for the days they actually used the loan amount.
So, for instance, if a client pays back 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 being accumulated per each day
The only calculation method in which interest is not accrued in Mambu is Fixed Flat. When using this method the interest will always reflect the amount that would be due on the due date, regardless the actual payment date.
The interest rate source allows organizations to fix their interest rate to a standard - index - which is determined externally.
The Days in Year will determine how interest will be accrued
Interest Calculation Methods
There are three different interest calculation methods you can choose from for your loan products:
- Declining Balance
- Declining Balance with Equal Installments
When creating a new loan product, you will need to choose one of these methods to be associated to that product and all the accounts created under it.
Next you can see how the repayment schedules would look like for each of the methods.
The loan details for every example are:
- Amount: 1000
- 4 installments
- Principal Payment Interval: 1
- Interest Rate: 10
- Interest Rate Frequency: Monthly
- Installments Frequency:Every Month
- Disbursement Date: 1/23/2011
- 365 days
This is the only method for which interest is not accrued over time. All interest and principal become due immediately upon disbursement and regardless the first repayment date.
The interest due depends only on the interest rate, principal amount and time between repayments.
Declining Balance methods reflect the actual cost of the loan more accurately than the Flat methods as the interest is calculated on the outstanding balance.
The clients will then be paying interest only on the actual amount they still hold and not on the total amount as it happens with Flat methods.
In this case, as the client starts making repayments, the interest due will keep decreasing over the duration of the loan.
Declining Balance (equal installments)
Just like for the Declining Balance method, the interest is also calculated on the outstanding principal amount. The difference in this method is that the client will pay equal installments for the duration of the loan as the interest decreases and the principal increases over the installments.
Non equal installments due to rounding and first repayment date
In some situations it can happen that one of the installments is different than the others.
This can occur, for instance, 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 - where, according to the product settings, the rounding occurs.
Capitalized Interest type is available only for declining balance interest calculation method. When this type of interest is used, the interest amount is capitalized into the principal balance and it will be increased from an installment to another. On the schedule, the principal amount will be allocated on the last installments, previous installments having only the interest capitalized.
Interest Rate Source (Fixed or Indexed)
In Mambu you can setup 2 types of interest rate sources, via "Interest Rate Source" configuration on the product:
Some organizations choose to provide their customers with a fixed interest rate, which is used for the the entire lifetime of the loan.
Some organizations on the other hand, fix their interest rate to a standard rate which is determined by an external entity such as government, for instance.
The loans can be then setup to be based both on a fixed interest rate established by the organization and by an index rate, determined for the external entity, which can vary over time implying that the loans need to be updated to reflect the new interest.
The frequency for which the interest is reviewed is determined when creating a product. If there is a new Index at that point, then all the loans using an Index Interest Rate will be updated.
Consider a loan with the following terms:
- Loan Amount:$1000
- Interest:5% (index) + 2% (Spread)
- Monthly Installments
- Disbursal date:13.12.2011
- Interest Review:Monthly
Now suppose that on January 1, the Central Bank keeps the Index rate to 5% and on February 1 increases it to 6%.
The change will affect the loan's repayment schedule:
- First installment on 13.01.2012 - Interest: 7% (5% Index + 2% Spread)
- Second Installment on 13.02.2012 - Interest: (6% Index + 2% Spread)
Index Rate Floor and Ceiling
Some organizations apply a floor (min) or ceiling (max) to index interest rates as well. That is, that the combined index + spread cannot be less than or more than a predefined value. These limitations can be setup on the product configuration. For accounts using this product, when their interest rate is set up or updated they are max out at the ceiling if it's defined, or do not go below the floor if it is defined.
Assume floor rate: 10% and ceiling rate = 20%
|Index Interest Rate||Spread||Actual Rate|
Days in Year
You can choose from four different ways to accrue interest on a loan:
- Actual 365/Fixed is the method that calculates the interest daily by counting the number of days in the calendar and uses a fixed 365 year length;
- Actual/360 also computes the interest daily by counting the number of days in the calendar, but uses a fixed 360 year length;
- 30E/360 counts the days from the calendar, but also introduces some changes on the months with 31 and 28 days;
- 30.42/365 is a method that calculates interest on each payment date, where every month is exactly 1/12 of the year and the number of days in a year is fixed at 365.
Particularities in the 30E/360 method
When using this method, when the month has 31 days, it will be considered as having 30. This implies that on the 31st of that month the number of accrued interest days will be the same as on the 30th.
The last day of February is treated as the 30th day of the month.
Also, 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 on the calendar.
Particularities of the 30.42/365 method
When using this method, each month is calculated as 1/12 of the year, which is 30.41(6) days. For the days in a year calculation, a fixed year length of 365 days is used. The last day of February is treated as the 28th day of the month. Leap year is not considered for this calculation; the year will always be considered to have 365 days. Holidays are also excluded from the calculation.
Interest rate calculation according to 30.42/365 is calculated using present values. Interest is calculated at the same calculation time for all individual payments. The system uses iteration to calculate the effective interest rate at which the total of all present values is zero.