Amortization Methods Explained: Add-On, Diminishing Balance, and Rule of 78

The amortization method you choose decides how much interest a borrower pays and when. It also decides how your interest income lands in your books each period. Yet many small lenders copy a spreadsheet without fully understanding the method behind it — and then struggle to explain the numbers to a borrower or an examiner. This guide demystifies the three methods Filipino lenders use most.

Method 1: Add-on interest

Add-on is the simplest and the most common in Philippine micro-lending. You compute total interest as principal × rate × term, add it to the principal, and divide the total into equal installments. Interest is charged on the original principal for the entire term, regardless of how much the borrower has already paid down.

Take a ₱12,000 loan at 3% per month for 12 months. Interest is ₱12,000 × 3% × 12 = ₱4,320. Total payable is ₱16,320, or ₱1,360 per month. Clean and easy — but notice the catch: even in month 11, when the borrower has repaid almost everything, you are still charging interest as if the full ₱12,000 were outstanding. That makes the effective interest rate meaningfully higher than the nominal 3%.

Method 2: Diminishing balance

Diminishing balance (also called reducing balance) is how banks and most formal lenders compute interest. Each period, interest is charged only on the remaining unpaid principal. As the borrower pays down the loan, the interest portion of each installment shrinks and the principal portion grows. With a fixed monthly payment, early installments are mostly interest and later ones are mostly principal.

This method is fairer to borrowers and its quoted rate is much closer to the effective rate — a 3% diminishing rate really does behave like about 3%. It is slightly more complex to compute because each period depends on the last, but any amortization engine handles it instantly.

To see the difference concretely, put the same ₱12,000 loan at 3% per month for 12 months on a diminishing schedule. In month one, interest is 3% of the full ₱12,000, or ₱360. But by month six, roughly half the principal is gone, so interest is charged on about ₱6,000 — only ₱180. By the final month it is a few pesos. The borrower who took the diminishing loan pays substantially less total interest than the add-on borrower, even though both were quoted "3% per month." The only difference is what balance the 3% is applied to. This is precisely the gap the Truth in Lending Act's effective-rate disclosure exists to make visible.

Method 3: The Rule of 78

The Rule of 78 is not a way to compute total interest — it is a way to allocate a fixed total interest across the term, front-loading it into the early months. The name comes from a 12-month loan: 12 + 11 + 10 + ... + 1 = 78. In month one you earn 12/78 of the total interest, in month two 11/78, and so on down to 1/78 in the final month.

Why does this matter? Mostly for pre-payment. Because interest is earned faster than principal is repaid under the Rule of 78, a borrower who settles early has paid proportionally more interest than under a straight-line allocation. The method is legal but must be disclosed, and consumer-protection rules increasingly scrutinize front-loading — so if you use it, be transparent about how early settlement is computed.

The schedule is a guide, not the record

Whichever method you pick, remember a crucial accounting principle: the amortization schedule is a plan, not a ledger. Borrowers pay early, pay late, pay partially, and incur penalties. Your books should reflect what actually happened — the real collections, with each payment split into principal, interest, penalties, and charges — while the schedule serves as the guide you measure against.

A borrower who pays ₱1,500 against a ₱1,360 scheduled installment is not "overpaid on the schedule" — they have paid the installment plus a penalty or advance. Your records, not the table, tell the real story.

Let the engine do the math

LendKoPH supports seven interest methods — add-on, diminishing balance, Rule of 78, and more — and builds the amortization schedule automatically or lets you enter it manually. When you collect, you allocate the payment across principal, interest, penalties, DST, and other charges, and those records post to your books. The schedule guides; your collections govern.

Understand the method, disclose the effective rate honestly, and keep your records true to what borrowers actually paid — and both your borrowers and your examiners will trust your numbers.