Calculating the Interest Based on Diminishing Balance
Some loans, however, are payable on a monthly basis. This means that the principal amount of the loan will be reduced each month --- thus the interest rate cannot be calculated on a straight-line basis. Instead, computations shall be performed after establishing the diminished balance of the loan.
To calculate the interest for the first month, the value used as principal is still the original loan amount, which is $20,000 based on the givens. The interest, however, is calculated on a per-month basis, and the base year used is 365, since the formula will now use the exact number of days.
For this example, the $20,000 principal is to be divided into six monthly installments, which is equivalent to $3,333.33 per month.
(1) Interest for the first month (May 15 to June 15) = $20,000 x 5% x 32/360
= $1,000 x 32/365
Interest for the 1st month = $87.67
(2) Interest for the second month (June 16 to July 15) = ($20,000 - $3,333.33) x 5% x 30/365
Interest for the 2nd month = $16,666.67 x 5% x 30/365
= $833.33 x 30/365
Interest for the 2nd month = $68.49