To save loan interest, change the payment frequency
The Sunday Nation
Nairobi,
07 December 2014
Do you remember the school that was planning to buy a bus? If not, let me jog your memory: They wanted to get a 67-seat bus costing Sh14m but I suggested to them that they can get better value for money with two 51-seaters costing the same Sh14m! The logic was that they get more seats (102 compared to 67) for the same money.
They took my suggestion and opted for two buses. This came with an unexpected bonus: a “quantity” discount of over Sh300,000 was offered by the suppliers!
Now the school doesn’t have the Sh14m; the plan is to get a bank loan. Several banks are willing to give the money and the best interest rate quoted is 14 per cent for a five-year loan.
Banks know that schools get cash three times per year – at the beginning of every term. Therefore they have designed school-friendly loan schemes where instalments are paid in January, May and September.
It works well but it ends up costing more than when the payments are made monthly even though the interest rate and the period of the loan is the same. To understand why this is so, suppose you borrow Sh14 repayable in five annual instalments.
If you get the money in January 2015, then your first payment will be due in January 2016. Therefore, for the whole of the year 2015 you will be owing the bank the full Sh14.
Come January 2016, the interest will be calculated on the full amount; that is, 14 per cent of Sh14m = Sh1.96m. The total annual instalment will come to just over Sh4m out of which Sh1.96m will be interest charges.
If, however, you paid two annual instalments, the first payment will be in July 2016 (NOT June!). At that time, interest on Sh14m will be calculated for only six months; that is a half of 14 per cent of Sh14m = Sh980,000.
Your total instalment will be slightly under Sh2m out of which Sh980,000 is interest. The remaining Sh1.02m would go to offset the principle sum. Thus after this first payment, you will now owe the bank Sh12.98m.
In the second six-month period from July to December 2015 the interest will be calculated on the Sh12.98m balance; that is a half of 14 per cent of Sh12.98m = Sh908,600.
Therefore, come January 2016, the total interest will be Sh980,000 + Sh908,600 = Sh1,888,600. This is Sh71,400 less than when the payments are made annually…and it’s just in the first year! By the end of five years, the total savings come to Sh458,000.
For this reason, I have advised the school to opt for 12 monthly instalments instead of the three “temly” ones. This way, it will save about Sh233,000 even though the loan will still be paid in five years. All that is needed is a little extra financial discipline and I am confident that they have it.
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