Choosing the best method to finance construction
The Sunday Nation
Nairobi,
18 September 2011
Jack (not his real name) is planning to build a house worth Sh900,000
and is wondering how to finance the project. He is considering three
options:
The first one is to take a loan of the whole sum of Sh900,000 and repay
over a period of 72 months (six years) at an interest rate of one
percent per month. The second option is to borrow Sh150,000 every year
at the same interest rate. The final method is to save an amount
equivalent to a monthly instalment of the loans above and gradually
construct the house for a period of 72 months. He asks: “If we factor
inflation, which of the three financial alternatives will be the
cheapest
Now, in the reducing balance method, interest is only calculated on the
remaining unpaid loan amount at the beginning of each month. There are
two ways of doing this.
Some financiers divide the principal amount by the number of months and
then calculate the interest monthly. That is; Sh900,000 divided by 72 is
Sh12,500.
Thus on the first month, Jack owes Sh900,000. One percent interest comes
to Sh9,000. Therefore, the first instalment is Sh21,500. The balance in
the second month is Sh887,500 (Sh900,000 – Sh12,500), so the interest is
Sh8,875. Hence the second payment is Sh21,375 and so on.
The more common method of applying the reducing balance principle is to
work out a constant monthly instalment over the duration of the loan. In
the case of Sh900,000, the repayments come to Sh17,595 per month for six
years. I highly suspect that Jack’s financier will do it this way,
therefore the total cost of the loan will be Sh1,266,840.
If Jack takes the second option of borrowing Sh150,000 each year, the
monthly instalments will be Sh13,300. Therefore the total cost after six
years will be Sh957,600.
But there is a problem: due to inflation, it is unlikely that Jack will
be able to complete the construction through this plan. In the last 12
months, for example, the prices of goods have increased by an average of
16.6 percent. However, this does not mean that this rate will remain
constant for the next six years!
A better estimate of future price movement would be to look at the last
five years. According to the Kenya National Bureau of Statistics, the
(re-calculated) average Consumer Price Index (CPI) for 2005 was 72.57.
The figure for 2009 was 106.26. This means that in the five-year period,
prices of goods increased by about 46 percent, or just under 8 percent
per annum.
So, if Jack borrows Sh150,000 this year, he is likely to need Sh162,000
in 2012; then Sh175,000 in 2013; another Sh189,000 in 2014; Sh204,000 in
2015; and finally Sh220,000 in 2016. The total construction cost will be
about Sh1.1 million instead of Sh900,000 – inflation adds Sh200,000!
His monthly instalments in each year from 2011 through to 2016 will be:
Sh13,300; Sh14,400; Sh15,550; Sh16,800; Sh18,125; and Sh19,550,
respectively. Therefore, the total payments in six years come to
Sh1,172,700.
Now in the first option (taking the full Sh900,000 and repaying Sh17,595
per month for six years), the cumulative payments come to Sh1,266,840.
Thus it appears that the second plan is Sh94,000 cheaper. However, if
Jack chooses the latter method, he will have to wait six years before he
can move into his new house. During that time, he will continue paying
rent as well as the instalments for the loans.
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