How much interest do you really pay?
Question: I have a small business that constantly requires money to finance the credit that I extend to my customers. Since I still don’t have excess funds, I rely on borrowings from informal lenders, specifically those who offer “5-6 loans.” Some people told me that a “5-6 loan” is more expensive than advertised. But based on my computation, I am only charged 20 percent, much less than what formal lenders would charge. Could you enlighten me on the matter?—SME owner
Answer: There are many ways to compute the interest on loans in the country.
The three more common ones are diminishing balance, 5-6 and add-on-rate (AOR). Simply put, with diminishing balance, the interest gets smaller as the loan ages because the interest is based on the remaining outstanding balance. As the loan principal gets paid, the basis for interest also gets smaller.
For a “5-6 loan,” the typical explanation is that if you borrow P5, you will have to repay that with P6 over a short period of time. On an absolute basis, the lender in a “5-6 loan” would have profited P1 (or P6 minus P5). The P1 interest in relation to the original loan of P5 is 20 percent, hence the belief that a “5-6 loan” costs 20 percent in interest.
Simple interest loans are also computed in a similar but not exactly same fashion.
The interest on AOR, on the other hand, is computed by multiplying the quoted interest rate to the original loan balance.
Note that even if the loan principal is being repaid, the interest rate is still—and will always be—based on the original loan amount.
So with all of these different ways of computing interest, which one would come up with the actual interest paid?
Simple interest calculations are not enough as these assume that loans are fully paid only once and on loan maturity. In reality, loans are amortized over several periods, usually monthly. This is why a better way of computing actual interest paid is necessary.
The term used to denote the actual interest paid is effective annual interest rate. The computation is the same as computing interest under the diminishing balance method.
However, it would be too complicated and nauseating for us to discuss the intricacies of the computations in this short column.
Instead, I invite you to just download the country’s first free personal finance mobile application (app) called Ya!man. The mobile app currently runs on cell phones using the Symbian 40 operating system. Eventually, Ya!man will run on mobile phones using the Android and iOS operating systems. Currently, Ya!man may be downloaded from www.personalfinance.ph. However, the app will soon be made available in the various app stores as well.
Ya!man will help compute the effective interest rates on loans, whether they are on diminishing balance, 5-6 or AOR. The app also allows the user to include loan processing fees that reduce the net proceeds to the borrower and tends to increase his effective annual interest rate.
You would be surprised at the results you would uncover.
For example, a “5-6 loan” that lends P1,000 with repayment of P40 per day for 30 days actually has a whopping effective annual interest rate of 439 percent!
Ya!man can also assist in tracking a week’s budget using the ubiquitous cell phone. You would not need to carry paper, pen or calculator. Just key in your week’s starting budget and your daily expenses in your cell phone and see where your money actually goes. One week’s use will give you a realization. One month’s use will help you form the habit of really tracking and managing your cash flow.
The app can also give an idea of the amount of life insurance coverage that you will need given your particular financial situation. These computations include existing life insurance coverage, the annual cost of lifestyle of the people you will leave behind plus the years that they will need support before they are able to fend for themselves, as well as the assets they can readily sell upon your untimely demise.
Lastly, the app can compute the estimated inflated cost of a child’s college education or your retirement many years from now and given your desired quality of education for your children and your own lifestyle upon retirement.
Each computation comes with a brief analysis of the results as well as the opportunity to ask for clarifications from an onboard Ya!man personal finance expert via SMS.
The goal of the creators of Ya!man is to create a large community of empowered financial consumers, starting from personal finance knowledge. There are no spam text messages sent. And if and when Ya!man creators send official SMS, users will always have the right to “opt out.”
Now if you want a detailed discussion of interest rates as well as more knowledge on effective cash, debt, risk and wealth (CD-RW) management, come and attend the EnRich©CD-RW personal finance training now scheduled for October 18. You may also want to ask your employer to integrate personal finance training into your company’s employee benefits. Invite your company’s Employee Relations Manager to attend the EnRich©CD-RW personal finance training as well. There are limited free seats allocated for HR practitioners. Visit www.personalfinance.ph, e-mail [email protected] or call (632) 216-1541/(632) 359-3094 for more details.
(Efren Ll. Cruz is a registered financial planner of RFP Philippines, personal finance coach, seasoned investment adviser and bestselling author. Questions about the article may be sent by SMS to 09175050709 or e-mailed to [email protected]. To learn more about the RFP program, visit www.rfp.ph or e-mail [email protected].)
