As a bank customer, it’s important to understand what bank interest rates are and how to calculate them, especially if you plan to take out a loan in the future. Understanding this will help you avoid payment difficulties or debt problems.
If you’re still not familiar with how bank interest works, here’s a detailed explanation below!
What Is Bank Interest?
According to Indonesia’s Financial Services Authority (OJK), bank interest is a return provided by the bank to its customers for funds deposited, calculated as a percentage of the principal and term. It can also refer to interest charged on loans provided by the bank to its borrowers. In English, this is referred to as Bank Interest.
Simply put, bank interest is the return or cost applied when customers save or borrow money from a bank.
- When the bank pays interest to customers with savings, it’s called deposit interest.
- When the customer pays interest for borrowing money from the bank, it’s called loan interest.
Types of Bank Interest
There are two primary types of bank interest:
- Deposit Interest: Compensation paid by the bank to customers who deposit funds.
- Loan Interest: Compensation paid by customers who borrow money using bank loan facilities.
In banking practice, interest rates are further divided into five main types:
1. Fixed Interest Rate
This is an interest rate that remains unchanged throughout a specified period or until the loan maturity date.
Example: Many mortgages (KPR) and vehicle loans apply fixed interest rates.
2. Floating Interest Rate
Also known as variable interest, this rate follows market fluctuations. If market interest rates go up, your loan interest also increases, and vice versa.
Example: Some mortgages may apply a fixed rate in the initial period, then switch to a floating rate afterwards.
3. Flat Interest Rate
This method uses a fixed calculation based on the initial loan amount every month.
Due to its simplicity, the flat rate method is often used for short-term loans, such as unsecured personal loans, motorcycle financing, household appliances, and electronics.
Flat interest calculation formula:
Monthly Interest = (Principal x Interest Rate x Tenure in Years) / Total Months
Where:
Principal = Initial loan amount
Interest Rate = Annual interest rate
Tenure = Loan period in years
Total Months = Total number of months in the loan period
4. Effective Interest Rate
This method calculates interest based on the remaining loan balance. As the principal reduces each month, the interest also decreases.
This method is considered fairer by many borrowers, since the interest isn’t calculated on the full loan amount, but on what’s actually owed.
Effective interest formula:
Interest = Remaining Principal x Annual Rate x (30/360)
Where:
Remaining Principal = Balance from the previous month
Annual Rate = Annual interest rate
30 = Days in a month
360 = Days in a year (banking standard)
5. Annuity Interest Rate
This system is designed so that the total monthly payment (principal + interest) stays the same, even though the interest and principal portions vary over time.
In the early months, the interest portion is larger, while the principal is smaller. Towards the end of the term, the interest decreases while the principal increases.
This method is commonly used in long-term loans, such as investment loans or mortgages.
Annuity interest formula:
Interest = Previous Month’s Principal Balance x Annual Rate x (30/360)
To get the total monthly instalment, simply add the monthly interest and the principal repayment.
Note: In practice, banks often combine interest types, such as Flat-Fixed + Effective, where the rate remains the same during the fixed period, and later shifts to market-based effective interest.
The Function of Bank Interest
For banks, interest is a major source of income. When a bank lends money to a customer, the borrower must repay the loan with interest, usually in monthly instalments.
The interest paid by borrowers is what becomes the bank’s revenue.
For customers, bank interest also provides benefits. If you save your money in a deposit, the bank pays interest as a reward. This encourages people to keep funds in the bank, which the bank can use for lending or investments.
The interest earned is then added to your deposit balance based on the agreed terms.
