APR: How banks will quote loans costs in future
The Sunday Nation
Nairobi,
13 July 2014
Which is cheaper: a 2kg-pack of cooking oil going for Sh450 or a 2.5kg one selling at Sh550? The only way to find out is by calculating the unit cost; that is shillings per kilo for each package. It comes to Sh225/kg for the first one and Sh220/kg for the second one. Hence the latter is cheaper.
That’s easy to do especially when you have a calculator while shopping. Nevertheless, the Department of Weights and Measures has published regulations restricting the quantities that manufacturers can pack their products in. Unfortunately, however, the department’s inspectors have been sleeping on the job and as a result, there are many items in our shops that are packed in very awkward quantities, for example 2.25L of cooking oil. But that’s a discussion for a different forum…
Suppose that two banks offer you a one-million-shilling loan repayable in 5 years; one has an interest of 14% and 1% processing fees, the other 14.5% and 0.5% respectively. Which of these two is cheaper?
The only way you can find out is to look at the repayment schedule and compare the amounts above one million shillings. This way:
The first loan charges 1% processing fee, that is Sh10,000. Then at 14% for five years, you would pay Sh23,268.25 per month. The total instalments come to Sh1,396,095.
In other words, you will pay Sh396,095 in interest. Now adding the Sh10,000 initial processing fee brings the total cost of this loan to Sh406,095.
For the second bank, the initial fees is Sh5,000 and the monthly instalments are Sh23,528.28. Cumulatively, the total cost of this loan comes to Sh416,697: it is the more expensive one.
The challenge is that the process of calculating the cost of a loan is not as straightforward as that for, say, cooking oil. For that reason, the Kenya Bankers Association (KBA) has adopted the use of Annualised Percentage Rate (APR) in the banking industry.
The APR is calculated by adding all the costs of the loan – interest, mobilisation/processing fees, legal and other professional fees, etc – and using this total to work out the effective interest rate.
In our example the total cost of the one-million-shilling loan from the first bank comes to Sh406,095. Thus the total repayment in the five years is Sh1,406,095. Next; this is spread over the five-year period and it comes to Sh23,434.92 per month. Now we ask this question: what would be the interest rate on a one-million-shilling loan if the instalments are Sh23,434.92 per month for five years?
The answer is 14.32%. This is the annualised percentage rate – APR. For the second bank, the APR comes to 14.66%. Clearly the second bank’s APR is higher, therefore its loan is more expensive.
This is the method that KBA has adopted for quoting the cost of all
loans in
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