When is a loan expensive?

Question: The COVID-19 quarantine caught me by surprise. I was not able to save enough emergency funds.

With my cash running low, I will need to contract a personal loan. This is temporary though as I am optimistic that the qua­rantine will not last long and that I will be able to not only shore up my emergency funds but maybe even quickly repay my personal loan in full. How will I know if a loan is expensive or not? Asked at “Ask a Friend, Ask Efren” FREE service at www.personalfinance.ph, SMS, Viber, LinkedIn, WhatsApp, Instagram and Facebook.Answer: You appear to be looking at taking out a personal, noncollateralized loan. First, be aware that such loans bear interest that is much higher than regular collateralized debt like housing and car loans. Why? Because the lender is taking greater risks in lending without fallback collateral.

Loans come with different terms. To level the playing field between loans and know which is more expensive, we need to know their effective annual compound interest rate (ACIR). To put things into perspective, let’s first break down the two other common ways of quoting interest.

Simple interest is the total peso interest for the duration of the loan divided by the loan principal and divided by the term of the loan. A P10,000 loan payable over a term of 60 months at a monthly amortization of P311.37 will have a simple interest of 17.36 percent per annum. This was arrived at by subtracting the original loan amount from the product of the monthly amortization and the term. The answer is then divi­ded by the original loan amount and then further divided by five, the equivalent term of the loan in years. The answer is converted to percentage format to arrive at the simple interest.

Personal loans, however, typically use the add-on-rate (A-O-R) method when quoting their interest rates. A P10,000 loan payable over 60 months at a monthly amortization of P311.37 will have an A-O-R of 1.447 percent a month. Each periodic peso amortization is comprised of the original loan amount divided by the term of the loan plus a fixed peso interest equivalent to the A-O-R multiplied to the original loan. On an annual basis, the A-O-R per month translates also to 17.36 percent, or 1.447 percent multiplied by 12.

Both simple interest rate and A-O-R are also called nominal interest rates.

Now, a loan that is quoted using effective ACIR will equate to a fixed periodic peso amortization comprised of increasing principal and decreasing interest payments as amortizations are made and the original loan is paid down. The same P10,000 loan whose monthly amortizations were computed earlier at a 17.36 percent per annum simple interest and 1.447 percent A-O-R a month translates to an effective ACIR of 28 percent.

The effective ACIR is the only one among the three methods mentioned that reflects the equitable way of paying interest, that interest is paid only on the principal that is left unpaid. Given the foregoing assumptions, a lender can quote a more expensive level of simple interest or A-O-R on an annual basis of 25 percent and still appear cheaper on the surface level than the loan that is quoted on an effective ACIR of 28 percent.

But what about compounding? Compounding simply means that the lender will actually earn his interest income, say 28 percent effective per annum as in the example given, if he relends all of what he collects at the same 28 percent effective ACIR as and when he makes a collection.

So, always ask for the effective ACIR when shopping for loans. Lenders have the obligation of disclosing all of the attendant costs of a loan under the Truth in Lending Act. INQ