An elegant way of cutting the interest on a loan

By MUNGAI KIHANYA

The Sunday Nation

Nairobi,

11 January 2009

Timothy Mburu is considering taking a bank loan but wants to minimise the interest charges. He is toying with two options and wants to know which will cost less.

The first option (A) is to take a Sh500,000 loan payable in 48 months at 18.5 percent interest per annum. But instead of sticking to the bank’s payment schedule of Sh15,000 per month, he plans to pay Sh35,000. In Timothy’s own words: “After 12months, I top up the loan to Sh400,000 and continue paying Sh35,000 per month until the loan is completed.”

Before going to the second option (B), let us try to understand why he is juggling with the loan this way. If he stuck to the bank’s schedule and paid Sh15,000 (actually, Sh14,819 - but what’s a few hundreds between friends?!), the balance would be Sh407,000 after 12 months.

When he pays Sh35,000 monthly, his balance after 12 instalments is Sh143,000.  At that point, therefore, his plan is to to-up the loan (i.e., borrow more money from the same bank on similar terms) to Sh400,000 to make it seem as if he had been paying according to the bank’s schedule – bright chap, Timothy!

Now it is easy to understand option B, which is: Take a Sh500,000 loan on same terms as above and pay the scheduled Sh15,000 for 12 months. “After the first year, I increase my repayment to Sh35,000 until the loan is completed.”, says Timothy.

Now let us crunch the numbers and see which is cheaper. In the first 12 months of option A, Timothy pays a total of Sh420,000 (Sh35,000 times 12 months) and his loans balance stands at Sh143,000. This means that Sh357,000 out of the Sh420,000 went towards clearing the loan and the remainder (Sh63,000) was the interest charged.

Then he tops up the loan to Sh407,000 by borrowing an additional Sh264,000 and continues paying Sh35,000 per month until completion. This second phase will take 12 instalments of Sh35,000 and a final payment of Sh32,000. The total payment comes to Sh452,000.

Since the loan in the second phase was Sh407,000, it is clear that the interest charged is Sh45,000. Thus the total interest for option A is Sh108,000.

In phase one of option B, Timothy pays Sh15,000 for twelve months. This equals Sh180,000 in total. At that point, his loan balance is Sh404,000. Thus the interest charged is Sh84,000.

After this, he increases his repayments to Sh35,000 per month until the loan is cleared. This takes 12 instalments of Sh35,000 and a final payment of Sh28,000; the total is Sh448,000. The interest charged is therefore Sh44,000.

Thus the total interest for option B is Sh128,000. This is Sh20,000 more than that of the first plan. The big question then is why – if the two plans are similar?

It is because in the first option, Timothy makes extra payments at the beginning when the loan is large. This cuts the total interest charged during the first year. In the second phase, both plans are identical (well, almost) and therefore they attract the same amount of interest.

What’s the moral of this story? If you take a loan, start making additional payments immediately. This will greatly reduce the interest charged.