Why
interest on a loan is larger at the beginning
The Sunday Nation
Nairobi,
28 February 2010
Last week’s article got Jane thinking about her loan. She writes: “I got
interested because I have a mortgage which I took for a period of 15
years. The interest is fixed at 14.5 per cent for the first 5 years … I
get stressed when I realize that the bank is taking more than 80% of my
monthly repayment towards interest and only a very small amount goes
towards the principal amount loaned of Sh3.5m. My mortgage repayment per
month is Sh50,100. I still have a balance of Sh3.2m even after paying
for more than 3 years.”
Jane; I am concerned because your figures do not tally correctly. For a
loan of Sh3.5m payable in 15 years at 14.5 percent interest, the monthly
instalment comes to about Sh47,800. If you are paying Sh50,100, then the
amount you borrowed was Sh3.67m; or the extra Sh2,300 is for some other
administrative charge but not the loan itself.
Nevertheless, you are right: in the last three years, the bulk of your
payments have been going towards interest charges and only a small
fraction being applied to clearing the principle. But take heart, a time
will come when the situation will be reversed and most of the instalment
will be paying off the loaned sum.
The reason this happens is that in the early months of the loan, the
amount outstanding is very large. In your case it was Sh3.5m. The
monthly interest rate is about 1.21 per cent (14.5 divided by 12).
Thus on the first month, you were charged about Sh42,300 (1.21 per cent
of Sh3.5m) interest for keeping the banks money for 30 days. If you paid
Sh50,100, then the difference (Sh7,800) went towards paying the
principal.
Therefore, on the next month, your balance was about Sh3,492,200. The
bank applied the same rate of 1.21 percent on this figure and the new
interest amount came to Sh42,200. The second principal payment was
therefore Sh7,900.
Notice that the second month the scale tipped in your favour by Sh100.
This tipping continues throughout the term of the loan and towards the
end, the bulk of the payment will be going towards the principal.
Indeed, for the final instalment, the interest will represent less than
one percent of the payment.
But you continue to say: “I am expecting to receive some one million
shillings which I intend to put towards the principal amount.
Does this mean I will have to pay an early repayment
fee? When I enquired from the bank, they told me they would not charge
me anything if I decided to make a lump sum payment towards the loan,
but I know banks don't always tell the truth.”
Paying a lump sum makes lots of sense: it will save you large amounts of
interest. However, check the contract you signed and find out if there
is a charge for early repayment. One of the biggest problems at our
banks is that the majority of their staff are not knowledgeable about
the details of the loan contracts. So, don’t take their verbal words:
read it for yourself, or ask for a written commitment from the manager!
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