The Sunday Nation
Nairobi,
21 February 2010
Nick says he had borrowed about Sh300,000 from a bank and he intends to increase it to Sh800,000. The initial loan was payable in one year but he wants the new one to last for a period of two years. The interest rate applicable for both cases is 18.50 per cent.
He explains: “The bank has indicated that it will give me the 800,000 and subtract the balance of the other loan (about Sh150,000) from this so I receive Sh650,000. The question is: will I be paying more if I take this direction? Will I end up paying more in interest?”
Before going into the calculations of how much it will cost, I must say that this transaction leaves me wondering why Nick wants to to-up his loan. From a financial point of view, loans are generally not a good idea – unless they are use in the purchase of an asset that either makes or saves money.
Now, the one-year Sh300,000 loan at 18.5 per cent should be costing
about Sh27,575 in monthly instalments. I have done my calculation using
the “reducing balance” method, which is the most common amongst banks in
Some banks, however use the “flat rate” method where the interest is calculated on the full amount and the distributed equally over the months of the loan. In that case, the monthly instalment would be Sh29,625 – almost sh2,000 more.
Now Nick says that he has a balance of about Sh150,000 on the first loan. From that figure, it turns out that he is on the seventh month. The total payment so far is therefore Sh165,450 and out that, Sh18,889 has gone to paying the interest.
If Nick continues with this loan to the its end, he will pay about Sh25,000 in interest. Presumably, by topping up the loan, the bank will waive any early payment penalties. Therefore, using the part of the Sh800,000 to clear the old account seems to make sense.
However, the new loan is for a longer period (two years) than the first (one year); therefore, the total interest will be higher than that of the case of a one year loan.
Let us concentrate on the Sh150,000 that was used in clearing the old loan. If it is not cleared, it will be paid up in the coming six months. The total interest will come to about Sh8,200.
Extending the period from six months to two years increases the interest from Sh6,000 to over Sh30,000 – that’s the price of keeping the bank’s money for too long.
I would suggest that Nick takes a second loan of Sh650,000 and pays it back in the two years. That will cost a total of Sh132,000 in interest. Then he continues paying the old loan at the agreed rate for the coming six months – the charge here will be Sh8,200.
The total cost of the two loans will come to about Sh140,000. On the other hand, if he take the Sh800,000 and uses it to off-set the old loan, the total interest on this plan will come to Sh173,000.
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