As I discussed last time, money has a price, and this price is called interest. When you borrow money from a bank, a micro-financing institution or an informal money lender, you have to pay interest. However, interest rates and interest computations vary. It is thus important for any borrower to gain an understanding of the mechanics of interest.
First of all, interest rates vary. Interest rates (for loans) can go from as low as 4% per year, to as high as 200% or even more, if you borrow from loan sharks. For instance, some informal money lenders lend a person Php10,000 on Sunday, and collect Php2,000 every day after from Monday until Saturday. The loan is then renewed the following Sunday. The minimum implied interest rate of this arrangement is 20% per week. Interest rates vary depending on the nature of the loan, the length of time involved to repay the loan, the risk involved, the amount, the co-maker, the policy of the institution or person, and if any collateral is involved. It is often best to clearly delineate between needs and wants, and avoid spending beyond your means to minimize the chances of unwanted debt. Moreover, financial planning is needed to allow you to be able to apply for cheaper loans from expected expenses, such as tuition payments.
In corporate finance, interest is computed based on an interest or coupon rate (in the case of bonds) and is paid at agreed-upon dates, usually on a quarterly or semiannual basis. For instance, Php100,000 borrowed with an interest rate of 5% a year semiannual interest payments for 10 years require payments of Php2,500 every half-year, and a lump-sum payment of the principal at the end of the loan’s life. In consumer finance, such loans are not as feasible since ordinary consumers may have a harder time coming up with a big amount at the end of the loan’s life. Thus, many people opt for installment payment plans. This is when interest computations start becoming different.
Technically, if a loan of Php100,000 is borrowed by a consumer for 2% a month, and both parties agree to an installment payment, the entire principal is not borrowed throughout the duration of the loan. Instead, portions of the principal are repaid every period. For instance, if the loan agreement calls for a repayment of Php10,000 a month for 10 months, then strictly speaking, the 2% monthly interest should apply only to what remains of the borrowed principal. This process is called loan amortization. Thus, the interest payment goes down as the loan nears maturity. This will be illustrated in a table at the end of the article.
A variation of this used is called “add-on” interest and this is most often by financial institutions and banks on consumer loans. The same loan of Php100,000 for 10 months for 2% a month results in more money paid because the interest rate is applied to the whole principal throughout the life of the loan even if portions of the principal are already being repaid as the life of the loan progresses. This will also be illustrated in a table at table at the end of the article.
Finally, a third kind of interest is called “discounted” interest. In this case, the interest is already deducted from the loaned amount. For instance, the same loan of Php100,000 for 10 months for 2% a month discounted results in the interest already being deducted before the principal is released. Thus, if a person needs to borrow Php100,000, he would need to Php125,000 to receive a net amount of Php100,000.
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The table below illustrates the different payment schemes for Php100,000 net proceeds borrowed for 10 months 2% under different assumptions.
|
Month |
Amortized* |
Add-on |
Discounted |
|
1 |
12,000 |
12,000 |
12,500 |
|
2 |
11,800 |
12,000 |
12,500 |
|
3 |
11,600 |
12,000 |
12,500 |
|
4 |
11,400 |
12,000 |
12,500 |
|
5 |
11,200 |
12,000 |
12,500 |
|
6 |
11,000 |
12,000 |
12,500 |
|
7 |
10,800 |
12,000 |
12,500 |
|
8 |
10,600 |
12,000 |
12,500 |
|
9 |
10,400 |
12,000 |
12,500 |
|
10 |
10,200 |
12,000 |
12,500 |
|
Total** |
111,000 |
120,000 |
125,00012 |
*assuming that the person pays 10,000 a month of principal plus 2% interest for unpaid principal portion
**disregarding the principle of time value of money
Thus, it is important that you are aware of the terms of the loan, and if possible, ask for an explanation of the computation. The next column will talk about credit card debt, both the psychological and financial aspects of it.
***
The author teaches subjects under Interdisciplinary Studies, and Finance and Accounting Department at the Ateneo de Manila University. He can be reached via email at lyee@ateneo.edu for queries.
