Loans: when taking a lump
sum can be better small portions
The Sunday Nation
Nairobi,
11 July 2010
You know the way banks have been falling over one another pushing loans
whose interest is calculated on the “reducing balance” method? What
happens if the loan has an increasing balance? Would it be cheaper to
take the whole amount at ago or to withdraw small amounts on a monthly
basis?
This is the puzzle that Job Mwangi is trying to unravel. He writes: “If
one borrowed an amount from a bank for a particular duration and
withdrew the amounts in equal instalments, and interest is only charged
on what has been withdrawn, would the interest on loan be equal to that
when the whole amount is drawn at the beginning [but] for half the
period?
“For example; if you collected Sh1,000,000 every month at an interest
rate of 15 per cent and you begin repaying the amount at the end of one
year, would the interest accrued on that amount for the year be equal to
interest on Sh12 million borrowed over a period of six months?
“I'm involved in construction and I'm trying to figure out the cost of
financing for projects. Banks usually release funds in line with the
progress of the project and interest is only charged on the amounts that
have been drawn. Repayments begin after the last withdrawal. What I
actually need is a formula for calculating interest on an “increasing
balance” for the duration of the project.”
Whereas
banks quote interest rates per year, they work out the amount to be
levied on a monthly basis. Thus the first step is to divide the 15 per
cent by the twelve months of a year. This comes to 1.25 per cent per
month.
So, if you start by collecting one million shillings, then by the end of
the first month you would be charged Sh12,500 interest. When you collect
the second million shillings, the balance in the loan account now stand
at Sh2,012,500.
At the end of the second month the bank will calculate interest on this
balance; that is, 1.25 per cent of Sh2,012,500. This comes to Sh25,156
and it is added to the previous amount to bring your total owing to
Sh2,037,656.
This process continues until the end of the twelfth month. At that
point, your loan balance (including the interest) will be Sh13,021,116.
This is amount you will start repaying with your monthly instalments and
it will now work on a reducing balance since you will not be withdrawing
any further amounts.
Suppose now that, instead of following this monthly withdrawal process,
you collected the full Sh12 million and then accelerated the
construction work to be completed in six months. In that case, the
interest at the end of the first month would be Sh150,000 (1.25 per cent
of Sh12m) bringing the total balance to Sh12,150,000.
Another 1.25
per cent would be added at the end of the second month making a new
balance to
Sh12,301,875.
This process continues and by the end of the sixth month you will be
owing the bank Sh12,928,598.
This second figure is Sh92,518 less than the first one. So, taking the
full amount for six months is better than taking twelve small portions.
Even though Sh92,518 appears little compared to Sh12 million, don’t
forget that you will also save the interest on this amount throughout
the term of the loan.
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