The True Cost of Business Loans: Straight-Line Interest vs Declining Balance Interest

Understanding the cost of financing is crucial for small and medium enterprises (SMEs). Many businesses rely on loans to fuel growth, but the method used to calculate interest can significantly affect the total cost. The straight-line interest method may seem simple, but the costs are much higher compared to the declining balance method. This article will break down both methods, showcase the benefits of the declining balance approach, and provide a comparison to help you make informed decisions.

Understanding Straight-Line Interest

The straight-line interest method applies a constant interest rate on the original loan amount throughout the entire term. This calculation results in fixed monthly payments, which can create an illusion of stability. However, what’s predictable is not necessarily best for your finances.

Take a look at this example: If you borrow US$30,000 at a 5% monthly interest rate for six months, the monthly interest remains at US$1,500, even after you have paid down the principal.

Instalment	Principal	Interest	Payment due	Balance
0				$   30,000.00
1	$     5,000.00	$     1,500.00	$     6,500.00	$   25,000.00
2	$     5,000.00	$     1,500.00	$     6,500.00	$   20,000.00
3	$     5,000.00	$     1,500.00	$     6,500.00	$   15,000.00
4	$     5,000.00	$     1,500.00	$     6,500.00	$   10,000.00
5	$     5,000.00	$     1,500.00	$     6,500.00	$     5,000.00
6	$     5,000.00	$     1,500.00	$     6,500.00	$               -
	$   30,000.00	$     9,000.00	$   39,000.00

Therefore, the total interest paid after six months equals US$9,000, leading to a total repayment of US$39,000. The straight-line method may simplify your budgeting but will significantly inflate the overall cost of the loan.

The Declining Balance Method Explained

In contrast, the declining balance method calculates interest on the remaining loan balance after each payment. As you repay your loan, the interest cost decreases, ultimately lowering the total interest paid.

For instance, with the same loan of US$30,000 at 5% per month, the interest payment will vary each month based on the remaining balance. This means less interest accrues over time.

Here’s a simple breakdown of what this looks like:

Instalment	Principal	Interest	Payment due	Balance
0				$   30,000.00
1	$     5,000.00	$     1,500.00	$     6,500.00	$   25,000.00
2	$     5,000.00	$     1,250.00	$     6,250.00	$   20,000.00
3	$     5,000.00	$     1,000.00	$     6,000.00	$   15,000.00
4	$     5,000.00	$        750.00	$     5,750.00	$   10,000.00
5	$     5,000.00	$        500.00	$     5,500.00	$     5,000.00
6	$     5,000.00	$        250.00	$     5,250.00	$               -
	$   30,000.00	$     5,250.00	$   35,250.00

• Month 1 Payment: You pay interest on US$30,000, costing US$1,500.

• Month 2 Payment: Assuming a principal repayment, the interest is now charged on a smaller remaining balance, resulting in a lower cost.

The total cost of the same 5% interest is US$5,250, compared to US$9,000 with the straight-line method.

The Disadvantage of Declining Balance: Heavier Upfront Payments

One downside of the declining balance method is that it typically entails larger payments at the beginning of the loan term. This can strain the cash flow of businesses not yet generating significant revenue.

To help manage these higher payments, the Equal Monthly Instalment (EMI) method can be a useful alternative. The EMI declining balance method combines fixed monthly payments with the declining balance interest calculation, allowing businesses to have predictable fixed monthly payments while also benefiting from reduced overall costs.

How EMI Declining Balance Works

The EMI declining balance method fixes your monthly payment, meaning it stays the same for the duration of the loan. However, the interest is calculated based on the decreasing principal balance. This allows businesses to plan their budgets more effectively, knowing what their payments will be each month.

Here's what the repayment schedule looks like for the same loan, using EMI declining balance:

Instalment	Principal	Interest	Payment due	Balance
0				$   30,000.00
1	$     4,410.52	$     1,500.00	$     5,910.52	$   25,589.48
2	$     4,631.05	$     1,279.47	$     5,910.52	$   20,958.43
3	$     4,862.60	$     1,047.92	$     5,910.52	$   16,095.82
4	$     5,105.73	$        804.79	$     5,910.52	$   10,990.09
5	$     5,361.02	$        549.50	$     5,910.52	$     5,629.07
6	$     5,629.07	$        281.45	$     5,910.52	$               -
	$   30,000.00	$     5,463.14	$   35,463.14

Here, the total cost is US$5,463.14 - slightly higher than the cost of US$5,250 using the declining balance method, but still much lower than the cost of US$9,000 using the straight-line method.

EMI declining balance will always cost slightly more than "pure" declining balance because your principal payments are lower at the beginning of the loan and higher toward the end.

Key Takeaways for SMEs

When exploring options for business loans, it is vital to grasp the impact of the interest calculation method that your financier uses. While the straight-line method might offer deceptive simplicity, it carries much higher costs in the long run, because you're paying interest on money you've already repaid. Conversely, the declining balance method, despite heavier initial payments, allows for lower interest costs. The EMI declining balance method offers fixed payments at the same time as lower costs.

For small business owners in Zimbabwe, knowing the differences in these methods can lead to better financial choices and potential savings. When your financier tells you an interest rate, always ask: "What method do you use to calculate it?"