Sometimes we take loans without realising the implications behind it. If you decide to be a borrower, try as much as possible to be a smart one (Click to Tweet this thought). Why do we find ourselves strangled by debt, not being able to pay back or wishing we never took the loan in the first place? It’s because we do not understand the costs in the first place. We were dazzled by the shiny new item we were going to buy. It could have been a car or land. At that moment your main agenda is to get over and done with the process. You convince yourself all will be well somehow and things will just iron themselves out after you buy the car. It could be swiping that credit card for new clothes or a new phone. It could be that business loan you took just to relieve the pain temporarily. It could be your SACCO loan for the plot you were buying that you believe is the next big thing. The loan could also be for perfectly valid and borrowed for important reasons. You thought you did the right thing and you are shocked to find yourself struggling with it.
Let’s look at Mike. Mike was clear about his budget for a new car. He had always said that the maximum he would spend on a car is Kshs 1.2 million. Out of this, Kshs 200, 000 was coming from his savings and the rest (one million) he would borrow. He knew he did not want to spend more than that. That was 4 years ago with interest rates at the time. Mike recently got information on how debt works. He has now realised that he spent more than he actually wanted to. Mike has spent Kshs 1.6 million. This is because the interest that was remitted to the bank as part of his monthly repayment still constitutes a cost for Mike. The car is now worth Kshs 700, 000. Now for someone like Mike who was adamant about spending a total of Kshs 1.2 million, this revelation was not a welcome surprise. Had he known, he would have spent less on the car or made sure he borrowed less. Mike could have saved more i.e. pay a bigger balance in cash which would have reduced the cost of borrowing. Or simply buy a cheaper car. If he had borrowed Kshs 700, 000, then he would have gotten to his total cost of Kshs 1.2 million inclusive of the interest charges.
So why do we find ourselves in such problems?
We simply don’t think we have borrowed a lot so we keep borrowing. Yes, Mike borrowed Kshs 1.2 million but the cost to him was Kshs 1.6 million. Maybe if you have the Kshs 1.6 million in mind as opposed to the smaller number, it may affect your next borrowing decision. Maybe you will not easily swipe that credit card on that Kshs 10, 000 item if you knew that the item could end up costing you Kshs 14, 000 that year (give or take depending on how payments are managed). Imagine taking out the car loan, using a credit card, taking a personal loan for something or the other and even maybe borrowing from the SACCO all without understanding the impact of your borrowing decision. Like Mike, you will pay more than you bargained and obviously the monthly pressure will be more than you thought it would be.
We don’t only make mistakes with loans in terms of consumer decisions. Let’s say Nyambura buys a piece of land for the same amount of money as Mike’s car. She borrows the same one million at the same interest rate. When she buys the land she intends to sell it when she has made a profit of Kshs 800,000. So she wants to sell the land at Kshs 2 million. She reckons that’s a decent profit. Nyambura has done the right thing in setting a goal for her investment. The only thing is that she has miscalculated the true cost. The land actually cost her Kshs 1.6 million so her profit is halved. It is going to be Kshs 400, 000, while she thinks it is double that. Many people have actually done this and realised they did not make as much money as they thought. Others have even realised they made a loss. Imagine if Nyambura was in some some sort of emergency and sold it for Kshs 1.5 million. She may think there’s a small profit but she has actually lost money.
Now with both examples we have not included other costs that come with borrowing. There are costs called processing fees which can be anything from one to three percent of the loan amount depending on the bank and how you negotiate. If we assume they charge a very common two percent on the one million borrowed that’s an extra cost of Kshs 20, 000 on Mike’s car and reduction in Nyambura’s profit by the same amount. In the Centonomy classes we do several exercises on debt and people are always surprised to discover how much they still owe. The good news is, once you understand your loan there is still a way of reducing the cost to your advantage. So, if we decide to borrow let’s be smart about it. Don’t go in with eyes wide shut, glued together by the excitement of what you are buying or investing in. Debt is not all bad but ignorant debt is terrible (Click to Tweet this thought). Understanding the true cost will ensure that you are empowered in your decision making. Even if you have to borrow something that is not typically considered as good debt, you will know the impact and what you have to do. It may give you the impetus to wake up on Saturday and make extra money!
Waceke runs a program on Personal Finance and Entrepreneurship. To sign up, email her at waceken@centonomy.com| Facebook/centonomy or go to www.centonomy.com