Kamau is window shopping for a five year loan. There is a good investment opportunity that has arisen and he does not have all the funds he needs to access it. He is anxious about the rates he will be able to get because of the currently high interest rate environment. He first walks into the first bank and they give him a quote of 20% p.a. He then approaches a second bank and much to his surprise they give him a rate of 15% p.a. everyone he talks to tells him that is a good offer, as there are hardly any institutions offering that kind of rate in the current environment. It therefore becomes very obvious what his preferred option is. A week later he has quickly signed on the dotted line and walked away with Kes 1 million.
A few weeks later, Kamau’s wife is catching up on filling their financial records. She looks at the contract and notices that it states that interest will be calculated on a ‘simple interest basis or flat interest basis’. She finds that rather odd as other loans they have taken before always call it ‘reducing balance’. Anyway she figures Kamau must have known what he was doing and puts the document away. So what has Kamau actually signed up for?
Most loans are calculated on the basis of reducing balance. What this means is that interest is calculated and charged on a monthly basis only on the outstanding amount of the loan. From the monthly repayment there are two elements. Principle is the portion of the payment that reduces the outstanding balance of the loan. Interest is the cost you are paying for having access to the money. With the reducing balance loan, the repayment amount will be the same, but the interest portion of that payment will keep getting smaller as the loan is being reduced by what has been credited towards the principal on a monthly basis. As you come towards the end of the loan, you find that the interest payment is very minimal.
However in Kamau’s case, he will be paying the same amount of interest for the entire period. The interest will always be calculated on the basis of the initial amount borrowed throughout the entire five years. He does not get the benefit of interest being calculated on only the outstanding loan amount or reduced balance of the loan. The impact of ongoing repayment of principle is not considered at all. These kinds of loans tend to offer a more attractive interest rate but can work out to be more expensive. On the reducing balance method he would pay interest of Kes 589,633 over the five years. However on the simple interest method he will end up paying Kes 750,000 in interest over the same period. Though it was quoted at a much cheaper rate, the methodology used in interest calculation makes a huge difference.
When choosing a loan, apart from ensuring the purposes of the loan make sense, always make sure you know how interest will be calculated. Watch out for extremely attractive rates as there could be a catch!
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