How to Calculate Loan Interest Correctly
Flat rate or reducing balance? Monthly or annual? Most chama members don't understand how their loan interest is calculated. Here's a clear explanation.
Your chama charges '10% interest' on loans. But what does that actually mean? The answer depends on whether it's flat rate or reducing balance — and the difference is significant.
Flat Rate Interest
Most chamas use flat rate because it's simple:
Formula: Interest = Principal × Rate
Example: KES 50,000 loan at 10% flat
- Interest = 50,000 × 10% = KES 5,000
- Total repayment = KES 55,000
- Over 3 months: KES 18,333/month
The interest is calculated on the original principal regardless of how much you've already repaid. Simple to calculate, easy to explain.
Reducing Balance Interest
Banks and SACCOs use this method. Interest is charged only on the remaining balance:
Same example: KES 50,000 at 10% annual, 3 months
- Month 1: Interest on KES 50,000 = KES 417. Payment: KES 16,667 + KES 417 = KES 17,084
- Month 2: Interest on KES 33,333 = KES 278. Payment: KES 16,667 + KES 278 = KES 16,945
- Month 3: Interest on KES 16,667 = KES 139. Payment: KES 16,667 + KES 139 = KES 16,806
- Total interest: KES 834 (vs KES 5,000 flat!)
Which Should Your Chama Use?
Flat rate is standard for chamas because:
- It's easy to calculate and explain
- The interest goes back to the group (benefiting all members)
- Loan terms are short (1-12 months) so the difference is smaller
- Members prefer knowing the exact total upfront
The key is transparency: every member should understand how interest is calculated before they borrow. Put the formula in your constitution.