Don’t be fooled by financial jargon; interest is easy to calculate

By MUNGAI KIHANYA

The Sunday Nation

Nairobi,

18 March 2007

The article on how a bank can overcharge the interest on a loan has elicited quite some interesting responses. But James Gakuo’s seems to be the most unusual. He says; “I had taken a loan of Sh100,000 paid at Sh5,256 for two years at 16 percent interest. I can’t explain how they worked this out [since] the repayment from another bank, for the same amount also at 16 percent is less than Sh5,000. You are a genius, explain this!”

A genius? No, I am not one, but I also cannot see how the first bank worked out the repayment amount. The second figure sounds more sensible: by my calculation, the monthly installments for a two-year, sh100,000 loan at 16 percent comes to Sh4,896.31.

Even if we calculated the interest at a “flat rate” for two years, it would come to Sh32,000 (Sh16,000 per year). Adding this to the principal sum brings the total amount payable to sh132,000. If this is repaid in 24 months, then the Sh5,500 – not the Sh5,256 that James was paying…unless, the bank was charging some additional costs that were not clearly explained to the customer.

Doing the calculation in reverse, it turns out that the first bank was actually charging 23.4 percent and not 16 percent it claimed. As I said in the previous article, check carefully how the bank plans to calculate your interest to avoid being overcharged…and the calculations are not complicated at all – don’t be fooled by sophisticated financial terminologies.

Nonetheless, the most popular question regarding interest rates seems to be “how can a bank charge interest that is more than the initial amount loaned?” Well, this only happens when the customer defaults on the payments.

If the borrower doesn’t make the monthly installments, the interest accumulates very quickly because it is compounded. This means that the customer is charged interest on the unpaid interest in the same way that a savings account earns interest on interest.

Suppose that James Gakuo had taken the second loan and he was the unable to make any payments from the beginning. At the end of the first month, the bank would charge him 1.333 percent interest bringing his balance payable to Sh101,333.

On the second month, the interest would be calculated on the new balance of Sh101,333 bringing the new total to Sh102,684. Now this appears like a small amount but if the process continues for four and a half years, the loan balance will be over Sh200,000 – more than double the amount loaned.

Now, there has been quite some debate regarding the so-called “induplum rule” that requires banks not to charge interest greater than the amount loaned: my take on the issue is that if we implement this rule, then we should also have another one saying that banks shall not pay interest on savings accounts that is higher than the amount saved. It’s only fair.