Loans: how 5% interest can be equal to 97%
The Sunday Nation
Nairobi,
06 May 2012
Mundia Akala went out looking for a loan from independent credit companies (not banks) and was surprised by the interest rates charged. The first company offered the money (Sh100,000) at an interest rate of 5 per cent. When they did the calculations, he was advised that he would be paying Sh13,334 per month for one year.
That figure did not sound right so Mundia checked it with an online loan calculator. It turned out that the interest rate was about 97 per cent per annum. Not convinced that this was fair, Mundia went to a second company where he was offered the same 5 per cent interest.
But this time round, the loan is to be repaid in six months at Sh21,693 per month. Checking with the online loan calculator revealed that the interest rate was also about 97 per cent per annum.
Now Mundia is wondering whether the online calculator is correct: “I’m not sure who is telling the truth. Could these guys be stealing from desperate and ignorant Kenyans? Please explain to me how they arrived at their figures.”
I think the best person to answer that question is the one offering the loan. One glaring omission in the offer, however, is that it does not say over what duration the 5 per cent is calculated: is it per year, per month, per week or what?
Banks always quote the interest rate per annum; but many non-bank loan companies quote their rates per month – this is the case with co-operative societies (most of whom publicise one per cent per month), credit cards and the independent personal finance companies.
From the figures given by Mundia, we can try and establish how the loan companies are doing their calculations. The first company asks for 12 instalments of Sh13,334 each. Therefore, the customer will pay back a total of Sh160,008 after taking a loan of Sh100,000.
I suspect that the intended repayment figure is a flat Sh160,000 (after all, 160,000 divided by 12 is 13,333.333…). This means that the customer pays a sum of Sh60,000 as interest. Comparing 60,000 to 100,000, we immediately notice that it is 60 per cent.
Now how does 60 per cent relate to the 5 per cent quoted by the loan company? Well, 60 divided by 5 is 12; therefore, it turns out that the quoted rate is 5 percent per month. Similar analysis reveals that the second company is also quoting a rate of 5 per cent per month.
But what about the online calculator? Why does it give the applied rate as 97 per cent?
The answer is that the calculator assumes the loan repayments are done on the “reducing balance” method. That is, interest is only charged on the principal amount remaining unpaid each month. But that is not what the loan companies are doing: they are calculating the full interest of the loan assuming that nothing is paid. That’s why their rates are so high.
 |
 |