251. When Paying 7% Is Actually Cheaper Than Paying 5%

It sounds impossible at first. 

After all, we were taught a simple rule: the lower the interest rate, the better the loan.

So if one lender offers 5% and another offers 7%, the choice should be obvious, right?

Not always.

In the real world—especially in the Philippine lending market, 

how interest is computed can matter more than the number itself. 

And sometimes, paying 7% really is cheaper than paying 5%.

Let me show you why.

The Two Ways Lenders Compute Interest

Before we compare numbers, we need to compare methods.

The two most common ones you’ll encounter are:

• Add-On (Flat) Interest
• Diminishing (Reducing Balance) Interest 

They don’t just look different. They behave very differently.

The 5% Add-On Loan: Cheap on Paper, Expensive in Reality

With add-on interest, the lender computes interest on the original loan

amount for the entire loan term.

Even if you’re already paying down the principal,

you’re still being charged interest as if you haven’t.

So a “5% per month add-on” loan means:

• Interest is calculated on the full amount, every month, for the whole year
• The total interest is pre-computed, added to the loan, and divided into equal payments
• Your monthly payment looks simple and flat, but the true cost is hidden

Sample:

Borrow ₱100,000 for 12 months at 5% add-on per month

• Total interest = ₱60,000
• Total paid = ₱160,000

When you compute the true effective rate, that “5%” loan turns out to cost about 154% per year.

Yes—154%.

The 7% Diminishing Loan: Higher Number, Lower Real Cost

With diminishing (reducing balance) interest, the bank computes interest

only on what you still owe.

As your balance goes down, the interest goes down too.

So a 7% per year diminishing loan:

• Charges interest fairly, based on the remaining balance
• Gradually shifts your payments more toward principal
• Results in much lower total interest over the life of the loan

On the same ₱100,000 for 12 months, the effective annual rate is only

about 7.23% per year (slightly higher than 7% because of monthly compounding).

Same Borrower. Same Amount. Very Different Outcome.

Let’s put it side by side:

• 5% add-on → Effective cost: ~154% per year
• 7% diminishing → Effective cost: ~7.23% per year

So yes:

In real life, paying 7% can be far cheaper than paying 5%.

Because the real question is not:

“Which rate is lower?”

The real question is:

“How is this interest being computed?”

Why This Confuses So Many Borrowers

Because many of us were trained to look only at:

• The monthly payment
• The advertised rate
• The “simple” explanation at the counter

And to be fair, add-on loans are:

• Easier to explain
• Easier to sell
• Easier to budget for (same payment every month)

But they are often much more expensive in total cost.

Banks, on the other hand, usually use diminishing balance because it’s:

• More transparent
• More accurate
• More fair to the borrower

Even if the number looks higher at first glance.

The #acgadvice Rule Before You Sign Anything

Never decide based on the headline rate alone.

Always ask:

• Is this add-on or diminishing?
• What is the total amount I will pay?
• What is the effective annual interest rate?

Because:

The most expensive loans are often the ones that look “cheapest” on the poster.

All the best my friends!!

#acgadvice