How a bank can over-charge interest on your loan

By MUNGAI KIHANYA

The Sunday Nation

Nairobi,

04 March 2007

A friend who wishes to remain anonymous recently took out a loan from one the Big-Five commercial banks in Kenya. The amount was Sh300,000, payable in 6 months at an interest of 2 percent per month. The bank calculated the repayment plan as follows:

The principal sum was divided by 6 to get sh50,000 per month. Then the bank calculated 2 percent of sh300,000 to get sh6,000 and advised the customer to be paying sh56,000 at the end of every month. Seems fair, doesn’t it? Well, not quite.

There is something wrong with the way the interest is calculated – the bank is charging interest on amounts not owed! This is how: By the end of the first month, the customer has kept the bank’s sh300,000. 2 percent of this is sh6,000. However, when the customer pays the first installment of sh56,000, the balance of the loan goes down to sh250,000.

Thus in the second month, the interest should be calculated on this sh250,000, not the original sh300,000. This comes to sh5,000 and the customer should then pay sh55,000 (instead of sh56,000). By the same reasoning, the third installment should be sh54,000… and so on until the last payment of sh51,000 which clears the loan.

If the calculation is done this way, the customer pays a total interest of sh21,000 in the six-month period, while the bank’s method charges sh36,000 – a difference of sh15,000.

This calculation is sometimes called the “reducing balance” method. In my view, it is the only correct way to calculate interest on a loan. What the bank in this example is doing is not only unfair, but can also be seen as fraudulent. Why are they charging for services (loan amounts) not given?

But the reducing balance method as illustrated above may be slightly confusing because the monthly installments are not equal. One quick method of achieving the equality would be to divide the sh21,000 interest by six. The result is Sh3,500, thus the customer may be asked to pay sh53,500 per month.

However, this would still not eliminate the original confusion of how the interest is being calculated. A more accurate calculation reveals that the monthly payment should be sh53,557.74. With this figure, the first installment comprises of sh6,000 interest (that is, 2 percent of sh300,000) and sh47,557.74 principal repayment.

After the first month, the loan balance becomes sh252,442.26 (sh300,000 minus sh47,557.74). Thus the second installment of sh53,557.74 now comprises of sh5,048.85 interest (2 percent of sh252,442.26) and sh48,508.90 repayment of the principal sum.

Notice that the interest is now a smaller amount than in the first month. This gradual decrease continues and on the final installment, the allocation is sh1,050.15 and sh52,507.59 respectively.

The total interest charged now adds up to sh21,346.46 – slightly higher than sh21,000 but still much less than sh36,000.

The moral of the story? If you have a loan, look carefully at how the lender is calculating the interest; you might be paying a lot more than your fair share.