WHY LOAN TOP UPS ARE BLEEDING YOU DRY

Recently, i had an interesting discussion online with one of my loyal clients and readers. For the purpose of this article, i will call him  James.  James had read my article STOP BORROWING LOANS TO SPICE UP YOUR LIFESYLE and had thus taken a loan of Kshs 600,000 from a local bank to purchase four dairy cows. The project he told me was doing well and had reported a monthly profit of Kshs 45,000 and he now wanted to add two more dairy cows. He told me that the monthly revenue was enough to meet his monthly loan repayment and leave a decent amount for other uses.

The bone of contention was then how to finance the purchase of additional dairy cows. James proposed to go back to the same bank and top up his existing loan. He argued that since he had repaid the loan for a year and it was a six year loan at 20% interest rate, he would thus apply for a top up. My argument was that he should save the cash he was getting from his existing project and thus buy the two dairy cows. I further told him that its better to apply for a fresh additional loan than to top up an existing loan. Here is my reason;

Most banks in Kenya charge interest through what is called reducing balance method; very few use the straight line method. Let me differentiate between the two;  in a straight-line method, interest for all years is loaded  upfront on the loan and the resultant figure is equally distributed on the repayment months This method is mainly used to calculate the interest payable for  SACCO loans and  Micro Finance loans. You pay interest on the entire loan balance throughout the duration of the loan. Flat interest rate calculation formula can be represented like this:

Interest Payable per Installment = (Original Loan Amount * No. of Years * Interest Rate p.a.  / Number of Installments

 In the reducing balance method, interest is charged on a monthly basis. This method is mainly used to calculate the interest payable for personal loans, mortgages, overdraft (OD) facilities, and credit cards. You only pay interest on the remaining loan balance. A reducing balance interest calculation formula can be represented like this:

Interest Payable per Installment = Interest Rate per Installment * Remaining Loan Amount

Back to our topic of discussion, though the reducing balance is cheaper than the straight-line method, reducing balance tends to be costly over the first half of instalments. This is because in the initial months of the loan term, interest payments take up much of the loan instalment leaving a smaller fraction to go towards the principal. In James’ case, out of the Kshs 14,371 that he pays as the first instalment, Kshs 10,000 goes towards the interest with only a paltry Kshs 4,371 going towards  principal payment and herein lies my argument that loan top ups are expensive affairs.
After the first one year of faithfully servicing his loan, James had parted with Kshs 172,462 but his loan balance was  Kshs 542,455. After the second year, he will have paid Kshs 344,928, more than half of the principal, but the loan balance will be only Kshs 472,282. So this was the math that tipped the argument to my favour.

Many people just like James are always in a rush to top up their loans so that they can sort out a pressing emergency. What many don’t know is that they end up wasting most of their hard earned cash on loan interests rather than channelling the same towards debt reduction.
The following is my advice on how we can overcome this problem of loan top ups that’s fleecing our pockets and enriching banks;

a)    If and when it’s a must to top up a loan, it’s advisable to wait at least one year past the half way point of the loan. This is because, at that point, the tide turns towards the principal and the larger part of the instalment goes towards principal reduction.

b)    Its always important to remember that loans are also insured, which also increases what we call loan costs. In the case of James, he had paid insurance premiums for six years, once a loan is topped up, its regarded as a new loan and new premiums must be paid. So the premiums he had paid for the next five years will go to waste.

c)     Patience is key when it comes to loan repayment. My advice is, never top up a loan, it’s even cheaper to take a new loan than to top up a long term loan.

d)   Always compare and contrast different loan rates. What many lenders show in their brochures is actually different fro what they charge. You can also check via this ONLINE LOAN CALCULATOR  and confirm for yourself that what you agree with your lender is what is right and correct.

e)     Click this link to like my facebook page, Stars of the Future where we learn and talk more about money, debts and savings.

So, i will leave you with a quote from Warren Buffet, “ Chains of habit are to light to be felt until they are too heavy to be broken “