Obviously, the longer you keep a loan, the more you pay for it!

By MUNGAI KIHANYA

The Sunday Nation

Nairobi,

05 October 2008

Michael Rotich is planning to buy a house but he is confused by the way banks calculate loan repayments. He says: “I went to the bank to enquire about a mortgage and the figures they gave me were scary. They said that if I take a one million shilling loan for ten years at 14.5 percent interest, I will have to pay back sh15,800 per month. But if I pay it in 15 years, the monthly installments come down to sh13,655.

“Now this means that by the end of the ten years (120 months), I will have paid them sh1.896 million. And on the 15-year plan the total comes to sh2.456 million. Why is the second figure so much higher than the first one, or did the clerk make a mistake?”

No Michael, there is no mistake (even though the first figure should be sh15,828). The reason why the second figure is much higher than the first is that you will have kept the bank’s money for much longer – 50 percent longer!

Most banks calculate installments on the so-called reducing balance method. I have explained the details of this calculation in a previous article, but in a nutshell, the interest is charged (monthly) only on the amount of the loan still unpaid. Thus the longer you keep the money, the higher the total interest you will pay.

However, since you are given a longer time to pay, the monthly installment will be lower. But the relationship between loan duration and monthly installment is not straightforward. That is, if you are paying sh15,828 for a ten year loan, you should not expect to pay a half of this (sh7,641) for a twenty year one.

The correct repayment is sh12,800 per month. Thus doubling the duration only reduces the installments by about 20 percent. Note that the total payment now will be over three million shillings.

Similarly, the relationship between the monthly installment and the interest rate is also not straightforward. For example, if the interest rate dropped by half from 14.5 to 7.25 percent, the monthly payment on the ten year loan would reduce from the present sh15,828 to sh11,740 – only 26 percent reduction.

The reverse is also true; when the interest rate increases by a small amount, the monthly installment jumps by a very big ratio. This is the main reason so many people end up falling in default and their houses are auctioned off by the banks.

All these calculations are not only tiresome but also confusing. To simplify them, I have made an easy to use loan planner that works the answers to the most common questions. It is available here free of charge.