Car Loan/Hire Purchase Financing in Malaysia. Learn about Flat Interest Rate Basis and Rule of 78 – The Classic Case of “Heads I Win, Tails You Lose”
What is Hire Purchase (HP)
In Malaysia, car buyers can get HP financing from financial institutions. HP agreements in Malaysia are different from HP in other countries so be careful if you’re using car loan calculators meant for other countries. Under an HP agreement, the financier (banking institution) is the Owner and the car buyer is the Hirer. Car ownership will be pass from the Owner to the Hirer after full repayments. The margin of financing is up to 90% of the purchase price with the loan period of no more than 9 years. Term charges (interest rates) can be either fixed or variable rates. However, in Malaysia, the majority of banking institutions only offer fixed rate (with a maximum of 10% per annum) HP financing.
Under the fixed rate HP financing, the following computation policies are adopted:-
- Flat interest rate method for calculation of total interest payable for the loan duration
Total interest payable for the loan duration is pre-calculated based on flat interest rate basis. This effectively requires the borrower to pay interest on loan amount already paid. This is in contrast with the “Reducing Balance” method (typically for housing loan) where interest is calculated after each instalment paid. (please refer below for further details)
- The Rule of 78 – method for allocation of total interest charged to each instalment for the loan duration
The interest portion of a fixed monthly instalment is higher in the earlier period of the loan period. This decreases the interest rebate for a borrower if they opt for an early settlement. (please refer below for further details)
Let’s look in details of item 1. and 2. above, the crux of this article.
1. Flat Interest Rate Method – “Heads I Win”
It is common for a car buyer to get Hire Purchase financing from a banking institution. The borrower (i.e. the Hirer) and the bank (i.e. the Owner) will sign a Hire Purchase Agreement (HPA) to seal the transaction.
The loan period and amount can be up to 9 years and 90% respectively. Total interest for the loan period is charged and pre-computed based on flat interest rate method i.e.,
(interest rate x loan amount x loan period)
This total interest payable i.e. cost of financing the car is a less fair method to the borrower (a.k.a. hirer in the HPA) as compared to the “Reducing Balance” method.
Why is it less fair to the borrower?
The total interest payable under flat interest rate method is PRE-CALCULATED based on the initial principal amount. It does not take into account the repayments made. This means the borrower is paying interest on the amount he has already paid. In other words, interest continued to be charged on the amount you have already paid.
However, under the “Reducing Balance” method, interest is calculated at the end of each month on the lesser amount outstanding after repayment.
2. The Rule of 78 Method – “Tails You Lose”
The borrower can settle the loan before the end of the loan tenure. A common situation is when the borrower buy a new car while owning an existing car with a loan outstanding.
Since the loan tenure has not expired, the interest portion of the unexpired period will need to be deducted from the total amount outstanding. This deduction is known as a rebate.
Common sense tells us the interest to be deducted is also based on flat basis i.e. simple unexpired period apportionment in line with the initial flat interest rate charge on the loan amount. Unfortunately, this is not the case. Instead, the bank adopted a basis called Rule of 78 also known as Sum of Digit method in the allocation of total interest charged. This method of interest apportionment effectively placed higher interest charges in the early period of the loan and progressively reduced towards the end of the loan tenure.
The Rule of 78 can be traced back to Indiana in 1935, immediately after the Great Depression. Lenders were typically doling out smaller amounts to borrowers over a period of 12 months with the unearned portion of the loans’ interest calculated at the time of disbursement of funds. This financing practice is highly controversial and in 1992, was outlawed in the United States for loans longer than 61 months. (Source: America’s Debt Help Organization)
The expression Rule of 78 was stemmed from 12 months of a one-year period. When the 12 months are added together,
1+2+3+4+5+6+7+8+9+10+11+12 = 78
The Rule of 78 methodology gives bigger weight in the beginning phase of the loan tenure when calculating interest. The objective is to discourage borrower from settling the loan earlier. This method also maximizes profits for the Bank.
For a 12 months loan, the weightage on interest for month 1 to 12 are as follows:
This method will only impact the hirer if he has the plan to settle the loan earlier. If the borrower pays the loan until expiry, the total interest paid is the same as the simple interest method.
What Should I Do?
At the moment, the Flat Interest Rate method and Rule of 78 are here to stay. The important thing is for borrowers to understand what they are getting into before buying a car.
Questions that need to be asked include:-
- Can I afford the monthly instalment?
- Do I intend to do an early settlement?
- How will it impact me financially if I decide to do an early settlement?
By understanding the terms and conditions of Hire Purchase (standard among banks) and compare different rates available, you as a borrower can help mitigate the loss of interest in early settlement by getting a better deal on the interest rate.