I want to share with you a question a client recently asked me.
You see, this client got loans before from various banks. As hers is a small business supplying vegetable products to restaurants in Metro Manila, most of her loans are actually housing loans. She just used the proceeds for her business.
Now that her business has grown, she can’t tap ordinary housing loans anymore. When she was applying for a business loan, she encountered a different payment mode than she was used to.
EQUAL PAYMENT versus DIMINISHING BALANCE
She asked me to arrange the loans for her, but also wanted to know which payment mode was more advantageous to her business. So I went to explain it to her this way:
This means that you have the same amount of regular payments to make at a specific period. Say, you got a Php 10 Million loan that charges you 10% interest per year for 5 years. If you accept the equal payment structure, you would pay a regular monthly amount of P212,470.45 or the next five years. This payment already includes principal and interest.
This means that you pay the same amount of principal every payment period, and then pay the interest on the loan based on the remaining balance. Say, you have the same Php 10 Million 10% interest loan, now you would be paying 250,000 in the first month, 247,916.67 in the second month, and 245,850.69 on the third month. This payment will continue to trend downward.
Why do they differ?
My client got slightly confused by this, so I explained to her the difference between the two. The equal payment method is derived from what we call the annuity formula. It was designed mostly for investors who wanted to get a fixed amount of return for their money invested. For loans, it simplified the payment and allows both the lender and the borrower agree on a fixed amount to be paid at regular intervals
There’s a downside to this payment method. The formula makes it so that you pay more interest than principal at the start of the loan. This means that your loan balance gets smaller more slowly compared to diminishing balance. This could be a disadvantage if interest rates change in the future, or you transfer the loan to another bank.
Compared to a loan with a diminishing balance, you get to pay a fixed amount of principal every payment period. The downside is a bigger initial payment, though your loan balance decreases faster.
In our example above, during the first month of the loan, here’s how the payment would look like. [PP mean principal payment, IP means interest payment, and BL means remaining balance]
Month 1 – PP – ₱129,137.11; IP – ₱83,333.33; BL – ₱9,870,862.89
Month 2 – PP – ₱130,213.26; IP – ₱82,257.19; BL – ₱9,740,649.63
Month 3 – PP – ₱131,298.37; IP – -₱81,172.08; BL – ₱9,609,351.26
Month 1 – PP -₱166,666.67; IP – ₱83,333.33; BL – ₱9,750,000.00
Month 2 – PP – ₱166,666.67; IP – ₱81,250.00; BL – ₱9,502,083.33
Month 3 – PP – ₱166,666.67; IP – ₱79,184.03; BL – ₱9,256,232.64
What should you choose?
As she was diversifying her business towards a rental property, we figured out that the equal payment mode would be easier to plan for. While there are a lot of considerations, we used a simple rule to determine what payment mode to choose.
1. When buying an asset with a consistent stream of income, choose the equal payment mode.
Since she was a buying an asset that would generate a consistent stream of income, it was better to get the loan with an equal payment mode. It was easier to plan for.
Also since the initial payment was smaller, the excess cash can be reinvested somewhere else.
2. When expanding the business using an asset that can create massive sales growth, use the diminishing balance method
If you are purchasing an asset which could result in a massive increase in cash flow (say, a license or an exclusive contract), then the equal payment method would be ideal. Your loan can be paid off faster, and banks would have an easier time accommodating requests for advance payments.
We tried to simplify the distinction between the equal payment and diminishing balance mode of payment. With the simple rules I outlined above, you should be able to gauge whether a mode is right for your needs.