What taking a loan means

This week the Centonomy class has been covering the very important topic of Debt. Have you been servicing monthly repayments on your loan for a while, and then gone to check the outstanding balance assuming that it must have reduced significantly only to find that it hasn’t? Well, there is a reason for that. What confuses most people is that they don’t understand how a loan works. Indeed some people in our class this week confessed that had they understood how it works they would have made different decisions. Well today let’s simply look at the basic principles behind your loan.

If have or want to take a loan, there are two components you must understand i.e. Principal and Interest. Say you borrow Kes 100,000 from your brother. At the end of the year you pay him back with Kes 110,000. You have to pay him back with more than you borrowed because there is an opportunity cost to him, for giving you this money. Had you not borrowed from him, he could have gone and invested that money somewhere else right? Well, the amount you borrowed i.e. the Kes 100,000 is referred to as the Principal. The extra Kes 10,000 is the interest you have paid. It is the actual cost of the money. As a financial literate borrower, it is always the cost of the money that needs to be considered. Financial Institutions will express this interest as a percentage. Many times people think they can afford to take a loan because they can afford the monthly repayment. That is not the case. Always seek to understand what interest you will be paying. The monthly repayment amount that you are servicing includes both components i.e. Principal and Interest.

Now let’s take this discussion to actual numbers. Say you took a car loan for Kes 1 million payable in 5 years. The interest you are paying on the loan is 18% per annum. Every month you will need to pay back Kes 25,393, which may seem relatively affordable. However in 5 years the total amount of interest you would have paid is Kes 523, 605. So you have bought your car not for Kes 1 million but over Kes 1.5 million. What will your car in 5 years be worth? Probably it will be worth only Kes 500,000. With this type of debt you have lost money and that is why it is referred to as Bad Debt. Your aim is to minimize the use of this kind of debt or seek to get out of it as fast as possible. Be good to yourself and also take time to understand what the opportunity cost to you is for taking out this car loan. If you bought an asset such as land with the Kes 1 million borrowed. It would possibly be worth more than Kes 1.5 mn hence you could sell it and still have money back in your pocket. Also ask yourself if you can afford that monthly repayment, what if you just opted to save up for the car instead or invest that money. If you invested it at only 8% per year at the end of the 5 years you would have about Kes 1.8 mn as opposed to spending the same amount of money only to end up with Kes 500k worth of a vehicle.

Now lets use the example of a mortgage to illustrate something different. Say you buy a property for Kes 5 mn and take a mortgage out for 20 years at 18% per annum. The monthly repayment will be Kes 77k per month. In the early years of the mortgage only about 2-3k per month is in fact going to reduce your principal whilst the huge balance is interest (i.e. the bank’s profit). That’s why you can have been paying your mortgage for so long only to find that the outstanding balance is so high. The total interest you will have paid over time is Kes 13 mn hence a total of Kes 18 mn for the apartment. Remember though that Kes 18 mn in 20 years will not have the same effect as 18 mn today and it is possible the apartment will be worth more than that. However it still doesn’t mean you cannot be clever with your interest. If you put an extra Kes 10,000 per month towards your principal, the total amount in interest you will pay drops down to Kes 6.8 mn (savings of about 7 mn) and instead of taking 20 years to clear your loan, it actually now takes only 11 years. So you spend an extra 10k per month in order to save time as well as Kes 7 mn. Sounds like a good plan to me and this technique is really the “get out of jail” card. You can use this same method for all debt including the car loan we talked about earlier.

So always understand what taking that loan means. Don’t simply be guided by the monthly repayment. The choice at the end of the day is up to you but be aware what that choice means. Do not let the desire for instant gratification cloud your judgment. Write to us and tell us about your experience with Debt.

Waceke runs a program on personal financial management. Find her at waceke@centonomy.com|

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