Methods banks use to
calculate interest
The Sunday Nation
Nairobi,
10 July 2011
Billy Ijusa wants to
take a loan but would first like to understand a few things. He asks the
following questions: “How do banks calculate interest? Some of them
claim to charge interest at 15 per cent, processing fee at 5 per cent
and insurance fee at 2.5 per cent … [but] if you look at the repayment
tables, the rate more than the 15 per cent they claim…
“Secondly, where does
the insurance fee go after repayment; is it not refundable? …. If I take
a loan of Sh500,000 when my salary is 26,000.00 after [statutory]
deductions, which repayment period would be economical?”
Without an actual repayment table from a specific bank, it is difficult to judge whether the calculation is wrong. However, should not stop me from explaining a few things.
When a bank says it will charge 15 per cent interest, it usually means the rate at which you will be charged on the balances that you owe. Since the repayments are done on a monthly basis, the interest is also calculated at the same frequency. This comes to 1.25 per cent per month.
Now there are two ways of doing the calculation. Some banks divide the principal loan amount over the whole duration and then calculate the interest every month as you pay the principal.
For example, if you borrow the Sh500,000 at 15 per cent on a 5 year term, it means that you should pay a principal amount of Sh8,333 every month. In addition, you also pay the monthly interest as follows…
In the first month, you owe the full Sh500,000 so the interest is Sh6,250 making a total repayment of Sh14,583. In the second month your balance is Sh491,667 so the interest is Sh6,146…and so on until the Sh500,000 is cleared.
If you signed up on such a plan, you would end up paying Sh190,625 as interest by the time you complete the loan.
Even though this method is easy to understand, the challenge is that the repayments are too high at the beginning. For that reason, a second system is used where the monthly instalments are constant.
Without going into the details of the formula, it turns out that the constant monthly instalments for the Sh500,000 loan would be Sh11,895. If you pay that for 60 month, the total repayment comes to Sh713,700. That is, the total interest is Sh213,700.
The reason why the interest paid is higher is that the principal repayments are small at the beginning. They then increase gradually, but all the time the total instalment remains constant.
The insurance charge is paid to an insurance company to protect the loan. The aim is to ensure that, if you died before finishing the loan, some one (the insurance company) will clear it for you. That way, your family will not be burdened by your debt. For that reason, that amount is not refundable – otherwise the insurance company will go bankrupt!
 |
 |