What interest rate should be applied on a private loan?

By MUNGAI KIHANYA

The Sunday Nation

Nairobi,

11 September 2016

Andrew Ngila is wondering how to work out the interest on some money he borrowed several years ago. He writes: “I borrowed Sh120,000 in 2008 and the owner wants the money back with interest, how can I calculate it, that is, what rates do I use? Is it in the law that the court can force me to pay with interest? It was a friendly loan and now the friendship is no more.”

The straight answer is yes: a court of law can force you to pay interest on the debt. By Practice Notice Number 1 of 1982, the Chief Justice fixed the rate at 12 per cent per annum “on the principal sum”.

My interpretation of that notice is that the interest not compounded. Therefore, the extra amount would be 12 per cent of Sh120,000 = Sh14,400 per year. So, for the period from 2008 to 2016, the total interest comes to Sh14,400 x 8 = Sh115,200. Adding this to the principal amount borrowed brings the total debt to Sh235,400.

There is another way that Andrew can use to work out a reasonable compensation for keeping the money for all these years. This involves factoring for inflation.

Inflation data is available from the Kenya National Bureau of Statistics (KNBS) running from 1962 to date. Instead of checking the year-by-year inflation rates, it is more convenient to compare the Consumer Price Indices (CPI) for the start and end dates of our period of interest. Such comparison yields exactly the same result.

According to the KNBS data, the CPI was 92 points in June 2008 and had climbed to 171 by August 2016. The inflation factor (note; not the “rate”!) is obtained by dividing final CPI by the initial one, that is, 171 divided by 92. The answer is 1.86.

In other words, since June 2008, prices of goods and services in Kenya have increased by a factor of 1.86. For example: an item that cost Sh100 in 2008 goes for about Sh186 today. Therefore, the things you could have bought with the Sh120,000 in 2008 will now cost you about Sh120,000 x 1.86 = Sh223,200.

Thus if Andrew wishes to just compensate his (former) friend for the loss due to inflation, he should pay back Sh232,200.

Finally, Andrew may choose to apply the average Central Bank of Kenya Rate (CBR). This is the minimum interest that the CBK charges on loans to banks. The average since 2008 to date is around 10 per cent per annum.

However, the CBR is compounded; that is, interest is charged on interest. 10 per cent per annum compounded over 8 years yields a factor of 2.14. That is, the Sh120,000 from 2008 grows Sh256,800 in 2016.

So, which of the three figures should Andrew pay: Sh235,400 or Sh232,200 or Sh256,800. There is no way of stating categorically; but at least, he has a basis for starting the negotiation.