UNDERSTANDING INTEREST RATE IN THEORY AND ITS MODIFICATION THAT IS USED IN REALITY

Author: Hanim Faizah 117785060

Surabaya State University Mathematics Department S2-Pascasarjana

CHAPTER I INTRODUCTION

Every entrepreneur and individual who have business will need money to invest and financial capital for their business. The decision to invest and financial capital is a decision that is related each other. Theoretically, the decision to invest and get financial capital is depend on the interest rate applied. Interest is a compensation that should paid by borrower to the lender. From the borrower side, interest is a cost of getting funds, whereas from the lender, interest is the profit of lending money (required return). Knowing the characteristics of interest rate will help to make decision in making investment and getting funds. Practically, interest rate is modified into some terminologies. Many marketing offer a loan using a low interest rate, whether those interest rate have their own characteristics. Consequently, many people who do not understand about its modification will be tricked. This paper will be investigated about the characteristics of the interest rate applied by money lender, such as banks and finance companies.

CHAPTER II INTEREST RATE IN REALITY

People who will propose a bank loans should understand about the interest rate of the bank loans. Banks may have different way to calculate their interest rate of the loans. Consequently, the interest rate in a bank is sometimes confusing for people who do not learn about banking theory. Generally, there are two types of interest rate in the bank, they are effective and flat rate. However, in the reality, there are some modifications of the effective rate. The modifications are used to make consumer easier to understand how to calculate the amount of the interest of their loan. Details of the interest on the bank are shown below: 1. Effective Interest Rate Effective interest rate is a method to determine the amount of interest based on the balance in the last month. Using this method, the main installment and the interest in every month will not be same, whereas the total installment in each month is always equal. This technique is usually applied in the long term loan, such as KPR (Kredit Pemilikan Rumah). This method, usually will be more useful for long-term installment. In this effective interest rate, the amount of interest in the beginning installment is high, and the amount of initial installment is lower than the interest. Commonly, banks are using a software to determine the amount of monthly payment using the effective interest rate.

2. Sliding Interest Rate In several banks, the Sliding Interest Rate is called as effective interest rate as well. But they have different method to determine the amount of interest in a month, so that the total payment in each month is different. The difference between them is shown on the table 1 and table 2. The formula to calculate the sliding interest is: Interest in a month = b I b = balance in the latest month I = interest rate in a year

3. Flat Interest Rate Flat interest rate is a method that is used by bank to calculate the amount of interest based on the principal debt outstanding. It is more understandable by consumer than the effective interest rate. It is usually applied for consumptive things installment, such as mobile phones, home appliances, or cars. The amount of interest and initial payment in every month will be same if it is calculated by this method. In many cases, the sum of all payment using flat interest rate is more than using effective interest rate. But, the interest rate per year is smaller than another one. For example, if the interest rate for effective per year is 10%, then it will get the same total payment in a month using interest rate 5,3739% per year for flat. To calculate the amount of interest in each month is: Interest total = P = Debt outstanding I = interest rate per year N = period of time to pay it off (in year) B = period of time to pay it off (in month) Besides two types of interest rate explained before, there is another system to find out the interest that is common to use in the banks, they are fix rate and floating rate. The difference between fix and floating rate is that fix rate has a fix interest rate during the period of installment. Conversely, the interest rate of floating rate is changeable based on the financial market condition at the time. Each of them has their own advantages for the consumer. So that, consumer should understand which method that is the most profitable for them. In the next page, it will show the details of payment rule in the banks.

CHAPTER III INTEREST RATE IN THEORY AND ITS MODIFICATION TO USED IN REALITY
Interest is the cost of borrowing money. An interest rate is the cost stated as a percent of the amount borrowed per period of time, usually one year. Basically, interest rate is divided into two types; they are simple interest rate and compound interest rate. Yet, in reality, such as in the banks, both of simple and compound interest is seems that they are not used. Banks prefer to use effective or flat interest rate. Actually, banks modify them, so that it is more understandable by consumer. Before studying about the modification of the simple and compound interest rate in the bank, the meaning of them is need to be comprehended: 1. Simple interest is an interest that is earned only on the original investment. Moreover, it can be said that no interest is earned on interest. The assumption used in the simple interest rate is that only the initial investment is invested whereas its interest is not. The interest of an investment using simple interest can be determined using this formula:

Where : b = interest rate of investment per period B = the interest in a period M0 = the capital Simple Interest = p * i * n where: p = principal (original amount borrowed or loaned) i = interest rate for one period n = number of periods

2. Compound interest differs from simple interest in that simple interest is calculated solely as a percentage of the principal sum. Compound interest can

be said that interest earned on interest. So that, in each period, the amount of interest will increase. The equation for compound interest is:

P = C(1+ r/n)nt
Where: P = future value C = initial deposit r = interest rate (expressed as a fraction: e.g. 0,06 for 6%) n = number of times per year interest is compounded t = number of years invested In reality, simple interest is not profitable for the money lender, such as banks, because it is inflict a financial loss. On the other hand, compound interest is frightening for consumer. They think that they need to pay more if compound interest is used. However, in all of finance company, for instance in bank or money lender, use compound interest to determine the interest of loan. For instance, if someone owes Rp10.000.000 from the bank, the interest rate per year is 12%. The table below shows the differences of the result of counting the loan using simple and compound interest. Table 3 Comparison between Simple Interest and Compound Interest Simple Interest Year 0 1 2 3 The Amount of Money 10.000.000 11.200.000 12.400.000 13.600.000 Year 0 1 2 3 Compound Interest The Amount of Money 10.000.000 11.200.000 12.544.000 14.049.280

From the table above, the difference of the amount of money that should pay is Rp449.280 (Rp14.049.280 Rp13.600.000). The difference is obtained because for counting simple interest, the interest in the (n-1)th year is not counted as an investment, so the interest in the nth month is counted only from the main investment. The other way, for compound interest, the interest in the (n-1)th year become an investment, so that the amount of money in the nth year of compound interest will be more than in the simple interest.

2.1 Effective Interest Rate Now, the interest rate that is used in the finance has been known that is compound interest rate. Moreover, compound interest rate become more complex because the compounding period become more variation, such as daily, weekly, monthly, semiannually, and annually. If the compound interest rate is related to the compounding period, the nominal will be more than the realization. The interest rate that is related to the compounding period is called Effective Interest Rate. For example, someone invest Rp10.000 to the bank using compound interest for 8%, 9%, 10%, and there are 5 kinds of compounding period, daily, monthly, three-month period, semiannually and annually. The differences among them can be shown on the table below. TABLE 4 Calculation for Effective Interest Rate Interest Rate 8% Annually 8,00% 800 9,00% 9% 900 10,00% 1000 Semiannually 8,16% 816 9,20% 920 10,25% 1025
Three-month period

Monthly 8,30% 830 9,38% 938 10,47% 1047

Daily 8,33% 833 9,42% 942 10,52% 1052

8,24% 824 9,31% 931 10,38% 1038

10%

From the table above, compound interest rate using daily compound period will get higher effective interest rate. The effective rate of an investment will always be higher than the nominal or stated interest rate when interest is compounded more than once per year. As the number of compounding periods increases, the difference between the nominal and effective rates will also increase. To convert a nominal rate to effective rate equivalently: Effective Rate = (1 + (i / n))n - 1 Where: i = Nominal or stated interest rate n = Number of compounding periods per year

For example, if someone will save his (her) money in the bank using compound interest rate 12% annually and monthly compound period, then the effective interest rate will be got is
12

1 + 0,12

12

1 = 12,68%

So, if someone saves Rp1.000.000 in the bank in the beginning of the year, then in the last will become Rp1.126.800, instead of Rp1.120.000. The effective interest rate is a method that used by the money lender to calculate the amount of payment. There are two ways to establish the compound period, they are annuity in arrear and annuity in advance. Annuity in Arrears Annuity in arrears is an annuity in which payments are made at the end of each period. The formula to count up the amount of payment is: = 1 1 +

Where: i = Nominal or stated interest rate n = Number of compounding periods per year Example: Suppose someone will owe some RP100.000.000 from bank, using compound interest 24% annually or effective interest rate 2% monthly because the compound period of the loan is monthly for 24 months. Using the formula above, the payment in every month can be determined. = = = 1 1 + 100.000.000 1 1 + 0,02 24 0,02 100.000.000 18,9139256

= 5.287.109,73 So, the installment should be paid in every month is Rp5.287.109,73.

The amount of installment is including the payment for the outstanding and the payment of interest in each of month. The formula that is used to count the interest in a month and the payment of the outstanding is shown below:

Installment = outstanding payment + interest payment Installment = outstanding payment + balance Outstanding payment = installment - balance

TABLE 5 Detail of Interest and Outstanding Payment in Each of Month Period 0 1 2 3 etc Installment Interest Payment 2.000.000,00 1.934.257,81 1.867.200,77 Outstanding Payment Balance

5.287.109,73 5.287.109,73 5.287.109,73

100.000.000,00 3.287.109,73 96.712.890,27 3.352.851,92 93.360.038,35 3.419.908,96 89.940.129,39

From table 5, in every period, the outstanding payment become increased, conversely the interest payment become decreased. If borrower wants to pay off the loan before the period, the amount of money that they have to pay is the last balance. For instance, for the problem in the example above, the borrower want to pay off the loan after the third installment, he (she) should pay Rp89.940.129,39. The total of payment using effective interest rate is more profitable for borrower, because if the installment counted using compound interest 24% annually, then the amount of installment in each month is: = = 100.000.000 1 1 + 0,24 2 0,24 100.000.000 1,456815817 68.642.857,14 = 5.720.238,10 12

= 68.642.857,14 =

the difference between payment using effective interest rate and payment using compound interest in a month is (5.720.238,10 5.287.109,73) =

Rp433.128,37. Annuity in Advance Annuity in advance is the opposite of annuity in arrears. It is an annuity in which payments are made at the beginning of each period. Annuity in advance is the method that is used in car or motorbike installment. This annuity can be determined by the following formula: 1+ 1 1 +
1

Where: i = Nominal or stated interest rate n = Number of compounding periods per year

Example: Suppose someone will buy a car which its price is Rp120.000.000. the down payment is Rp20.000.000, using compound interest 24% annually for 36 months. Payment in each month is: = 1+ = = 1+ 1 1 +
1

100.000.000 1 1 + 0,02 361

0,02

100.000.000 25,99861933

= 3.846.358,1 so, the annuity in advance should be paid in every month is Rp23.846.358,1. This nominal is including the down payment Rp20.000.000 and the first payment Rp3.846.358,1. In each payment has included the outstanding payment and interest payment. The difference between annuity in advance and annuity in arrears is annuity in advance has paid the first payment in the 0 th month. The table below shows the detail of the payment in each month.

TABLE 6 Detail of Interest and Outstanding Payment in Each of Month Period Installment Interest Outstanding Balance Payment Payment 0 3.846.358,10 2.000.000,00 1.846.358,10 98.153.641,90 1 3.846.358,10 1.963.072,84 1.883.285,26 96.270.356,64 2 3.846.358,10 1.925.407,13 1.920.950,96 94.349.405,67 3 3.846.358,10 1.886.988,13 1.959.369,98 92.390.035,68 etc 2.2. Flat Interest Rate Practically, the effective interest rate is modified by the money lender. The aim of its modification is to make calculation of the loan interest easier to understand by the consumer. Modification of the effective interest rate is called flat interest. Before calculating the flat interest rate for a loan, it will be determined the type of the effective interest that will be used, annuity in arrears or annuity in advance. Calculating flat interest for a loan is using the formula below: = 100% 12

Where: n = Number of compounding periods per year Example: Suppose the flat interest rate of a loan Rp100.000.000 using compound interest 24% annually in arrears for 24 months. It will be determined using the following formula. = = = 1 1 + 100.000.000 1 1 + 0,02 24 0,02 100.000.000 18,9139256

= 5.287.109,73 then, the flat interest rate will be = 100% 12

5.287.109,73 24 100.000.000 100% 100.000.000 24 12

= 13,45% From the example above, it can be known that for the loan Rp100.000.000 using compound interest rate 24% for 24 months (or it can be said using monthly effective interest rate) will get flat interest rate 13,45%. So, flat interest rate 13,45% and 24% will get the same payment in a month.

2.3. Comparison Between Effective and Flat Interest Rate It has been known that for the loan Rp100.000.000 using compound interest rate 24% for 24 months (or it can be said using monthly effective interest rate) will get flat interest rate 13,45%. So, flat interest rate 13,45% and 24% will get the same payment in a month. However, if the compound period changes into 12 months, 36 months, and so on, the flat interest rate will be changed as well. To determined the flat interest rate for difference compound period can be seen at the table: TABLE 7 FLAT INTEREST RATE FOR EFECTIVE INTEREST RATE 24% IN SOME COMPOUND PERIODS Compound Period 12 months 24 months 36 months 48 months 60 months Payment (Effective Interest Rate) 9.455.959,66 5.287.109,73 3.923.285,26 3.260.183,55 2.876.796,58 Effective Interest Rate 24% 24% 24% 24% 24% Flat Interest Rate 13,47% 13,45% 13,75% 14,12% 14,52%

From the table above, it can be seen that the changes of the compound period give effect to percentage of flat interest rate. In the 12-month period, the flat interest rate is 13,47%. Then in the 24-month period, it decrease to 13,45% (decrease 0,02% per year). But for 36-month period and so on, it become increasing. So, for economical reason, it will be more profitable if using 24 periods or 2 years for any amount of loan. More clearly, the increasing of flat interest rate from 1-year up to 20year period is shown in the graph:

GRAPH 1 THE EXPANSION OF FLAT FOR EFFECTIVE INTEREST RATE FOR 20 YEARS USING INTEREST RATE 24%

Flat Interest Rate

Graph 1 shows that flat interest rate will increase significantly for 20 years for effective interest rate 24%. So that is why the money-lender usually offers flat rate interest for a 3-year period until 5-year period loan. However, In another case, when the borrower wants to settle his loan before the end of period, the interest that will be applied is the effective interest. It is because in the beginning payment of effective interest rate, interest payment is bigger that outstanding payment. So that, the borrower will pay more and the money-lender will get more benefit. The graph 2 below show that the flat interest will increase significantly in the certain period, but in the another period it tend to stable. GRAPH 2 THE EXPANSION OF FLAT INTEREST RATE IN THE EFFECTIVE INTEREST RATE FOR 100 YEAR

Flat Interest Rate

Year

From the graph, flat interest from the first to the third year is about 14%, from the seventh to the eighth year is about 15%, from the ninth to the eleventh year is about 16%, from the twelfth to the fourteenth year is about 17%, from the fifteenth to

the eighteenth year is about 18%, from the nineteenth to the 24th year is about 19%, from 25th to the 33th year is about 20%, from the 34th to the 49th year is about 21%, and from the 50th to the 100th is about 23%. From the graph, it shows that the rate of flat interest will be stable for a long period. So that, the money-lender will find, which period that is the interest rate will increase significantly. So, it can conclude that flat interest is more effective if it used for short-period installment.

2.4. Floating and Fix Interest Rate When a borrower owes an amount of money to the bank, they will be given information about the interest rate used in the bank is fix or floating interest rate. Sometimes it makes borrower confusing, and now this paper will explain about them. Fix Interest Rate Fix Interest Rate is an interest rate that is fix from the first payment to the end of period. For example, if the borrower owe an amount of money to the bank using effective interest rate 24% per year. Its interest is valid trough the compound period, so it is called fix interest rate. Floating Interest Rate The opposite of fix interest rate is Floating Interest Rate. Floating interest rate is an interest that is determined by effectively to calculate and it is always changes based on the market interest rate condition. If the market interest rate condition is high, the floating interest rate is also high. Conversely, if the market interest rate is low, the floating interest rate is low. The consequence of the floating interest rate is changing of the cost of using money in the borrower side, and the changing of profit nominal in the lender side. Its fluctuation should be controlled, so it does not provide an ambiguity in the investment. There are two ways to anticipate the ambiguity of investment, they are: 1st Way is that the interest rate given is higher than market interest rate, and 2nd Way is controlled the interest rate not only from increasing or decreasing market interest rate among investment period. Comparison between Fix and Floating Interest Rate The advantages of using Fix and Floating Interest Rate: Fix Rate 1. Certainty in the amount of interest paid.

2. No changing although the market interest rate is changing Floating Rate 1. When the market interest rate is declining, the installment interest also declining. The advantages of fix interest rate for debtors are that they will get a certainty for the interest rate that has to paid in each period. Beside that when the market interest rate is increasing, debtors do not need to pay more. However, using floating interest rate also has advantage which is when market interest rate is decreasing, debtor will pay the interest less than the latest payment before. The disadvantages of fix and floating interest: Fix Interest 1. When market interest rate is decreasing, the interest payment does not decrease. It is fix although the market interest rate change. Floating interest 1. If market interest rate is increasing, the interest payment also increase agree with the market interest rate.

2.5. Sliding Interest Rate This interest rate is use simple interest to determine the amount of interest payment in each month. Sliding interest rate is rarely used by money lender. Because it is only give minimum profit for the money lender. Interest payment in a month is calculated using the formula below: Interest in a month = b I b = balance in the latest month I = interest rate in a year +

Where: m = number of compounding period From the formula above, interest payment in every month will decrease; it means that payment in every month will decrease as well. Example:

Suppose the interest rate of a loan Rp100.000.000 using sliding interest 24% annually for 24 months. It will be determined using the following formula. Interest in a month = b I == 100.000.000 24% 30 = 2.000.000 360 100.000.000 + 2.000.000 = 6.166.666,67 24

1 = 2 ==

95833333,33 24% 30 = 1.916.666,67 360

100.000.000 + 1.916.666,67 = 6.083.333,34 24

2 =

The detail of payment can be seen on the table 8 below:

TABLE 8 DETAIL OF SLIDING INTEREST PAYMENT Interest Total Outstanding Payment Payment Payment 4166666,67 4166666,67 4166666,67 4166666,67 2000000,00 1916666,67 1833333,33 1750000,00 6166666,67 6083333,33 6000000,00 5916666,67

Period 0 1 2 3 4 dst

Balance 100000000,00 95833333,33 91666666,67 87500000,00 83333333,33

CHAPTER IV CONCLUSION
Understanding the interest rate is needed by all entrepreneurs, not only debtor but also investor. For investor, it will help for finding alternates of profitable investment. On the other hand, for debtor it will give advantages for taking decision in loan with the minimum charge. From the explanation, before taking a loan from a bank, debtor should know some information, such as: 1. Many banks use flat interest rate for loan, the aim of using it is that bank want their debtor think that the interest that bank used is lower than when they are use flat interest or compound interest. So that, debtor need to get more information about the interest rate which bank used. 2. Every bank applies different way to count their interest. In this reason, when debtors comparing the interest rate of some banks, they have to know how bank calculate the interest of their loan. 3. Debtors should make sure the interest rate properties that bank used, floating or fix. If bank use floating interest and increasing interest rate is happened, so the payment will increase based on the interest increasing. And when interest rate is decrease, payment is decreasing as well.

REFERENCE

Devie. 2000. Tinjauan atas Suku Bunga dan Dampaknya pada Keputusan Investasi dan Pembiayaan. Jurnal Akuntansi dan Keuangan Vol. 2, No. 2, Nopember 2000. http://www.getobjects.com/Components/Finance/TVM/iy.html http://www.investorwords.com/1013/compound_interest.html#ixzz1qUKxGKSL
http://www.kartika.staff.gunadarma.ac.id/.../files/.../Materi+3b+Bunga+Kredit.pdf www.bi.go.id/NR/.../PerhitunganBungaKreditdenganAngsuran.pdf www.bi.go.id/NR/rdonlyres/...FE5B.../MemahamiBungaKredit.pdf

Some detail information from bank and finance company