Interest rate is not the only cost of a loan
The Sunday Nation
Nairobi,
08 December 2013
One of the great benefits that came with mobile phones is that, now, everyone has a calculator in their pocket…or handbag, as the case may be. These gadgets come in very handy when one is shopping because products on Kenyan shelves come in very awkward quantities.
For example, which is the cheapest: a 400g packet of spaghetti going for Sh55 or a 500g one selling at Sh65 or 700g at Sh100? The way to find out is by calculating the price per (common) unit for each weight, say, per 100g. Thus we get the following: Sh13.75, Sh13.00 and Sh14.29 per 100g, respectively. That is, the 500g pack is the cheapest,
Now, that is not a straightforward calculation that can be done mentally mentally. Dividing by four is ease: you simply halve the number twice over. To divide by five is a little more complex: you first multiply by two and then divide by ten. But how does one divide by seven? I need a calculator!
I think that the Trade Ministry’s Legal Metrology Department (not to be confused with the Meteorology people who are concerned with the weather!) must enforce uniform standard weights and volumes for pre-packaged goods.
This might prove cumbersome for imported goods that are originally packaged in imperial quantities (pounds, ounces, gallons etc.). Therefore, an alternatively approach may be tried out: the Ministry can issue regulations requiring traders to indicate the unit prices of all pre-packaged goods on sale, say per kilo and per litre.
But packaged goods are not alone in this: banks also present a similar problem. Which is the cheaper loan: one that charges 14% interest plus 2% processing fees or another charging 15% plus 1% , respectively?
At first look, both appear to be the same since 14 + 2 = 16 and 15 + 1 = 16 also. However, suppose you wanted to borrow one million shillings for one year, how would the two lenders compare? The processing fee at the first bank would be Sh20,000. Your monthly instalments would be Sh89,787. The total repayment then comes to Sh1,077,444, that is the cumulative interest is Sh77,444.
Therefore, the total cost of the loan is Sh77,444 + Sh20,000 = Sh97,444.
For the second loan, the monthly instalments are Sh90,258 making a total of Sh1,083,096 in 12 months. Thus the total interest charged is Sh83,096; adding the Sh10,000 initial processing fee brings the full cost to Sh93,096.
Clearly; even though the second loan has higher monthly instalments, it is actually cheaper than the first one when the processing fess are taken into account.
The way around this is for the Central Bank to force banks to quote the effective annualised percentage rate inclusive of all charges. To evaluate this, we start from the total cost of the loan and work backwards to find out the combined monthly instalment. From this, we then work out the resultant annual rate.
In the current example, the effective monthly instalments are Sh1,097,444 divided by 12 = Sh91,454 and Sh1,093,096 divided by 12 = Sh91,091, respectively. Thus the net annual percentage rates are 17.715% and 16.759%, respectively. It is now obvious which of the two is cheaper, isn’t it?
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