How do banks treat lump sum repayments of loans?
The Sunday Nation
Nairobi,
09 December 2012
Mjahid Hassan writes: “Suppose I borrowed Sh500,000 from a bank at an interest of 15 per cent payable over 12 months, then four months later get a windfall. I approach the bank with a lump sum of Sh200,000. How will this affect the repayment terms vis-à-vis interest payable or repayment period?”
There are three common ways in which this may be handled. In the first method, the bank simply applies the lump sum payment towards the principle amount and then re-calculates the monthly instalment.
Now, borrowing Sh500,000 at 15 per cent for 12 months means that the monthly instalment is Sh45,129. This is calculated based on the “Reducing Balance” method. Four months down the line, the principal balance will be Sh341,543.
If Mjahid paid Sh200,000 at this point, , the bank would credit this against the loan balance bringing it down from Sh341,543 to Sh141,543. This becomes the new principal and the recalculated the monthly instalment over the remaining eight months of the contract is Sh18,703.
But Mjahid may chose to continue paying the usual Sh45,129 per month. In that case, the loan would be cleared earlier – in about five months instead of eight remaining after the lump sum is paid. Thus if the instalments star in January and Sh200,000 is paid in May, the loan clears in September with a final payment of Sh14,441.
The second kind of bank would knock off a supplemental charge from the Sh200,000 – say, 10 per cent – and apply the remaining amount to the principal. Thus they would credit Sh180,000.
The reasoning behind this supplemental charge is that, when the bank lent the money out, it expected to earn a certain fixed interest thus it offered depositors interest rates based on that expectation. If the borrower pays earlier, the whole equation changes and the bank stands to lose money because it must continue paying depositors the promised amounts.
In this second method, the new loan balance after the lump sum comes to Sh161,543 and the re-calculated instalments are Sh21,345. If Mjahid continues paying the old Sh45,129, then still finishes the loan in September but the final payment is now Sh35,459 (compared to Sh14,441 from the first method).
The last method is to spread the Sh200,000 over the subsequent months at the rate of Sh45,129 each. This goes over four months and a balance of Sh19,484 spills into the fifth one.
The borrower is then advised to skip payments for the coming four months and to only pay Sh25,645 in the fifth one. After that, he will be asked to go back to the usual Sh45,129 monthly until the loan period expires.
Now this last method has no benefit to the borrower. The interest paid is exactly the same as when there was no lump sum. Thus instead of paying the Sh200,000 towards the loan, it would be better to put it in high-interest account (perhaps with a unit trust fund) and continue paying the loan instalments the normal way.
The important thing to note is that it is very important to understand how the bank treats lump sum payments BEFORE paying them, nay, before taking the loan in the first place!
 |
 |