I met James* at a training we facilitated last week. James took a mortgage of Sh10 million five years ago to buy his home.
James expected that after five years of making consistent monthly payments of approximately Sh140,000 without defaulting, he would be pleasantly surprised to find out how much he had actually paid down.
He told me he was horrified to find that his outstanding loan balance after five years was still Sh9.5 million; he had only paid down Sh500,000 towards his loan!
This prompted him to go through his finance records; James found that in those five years, he had paid out a total of Sh8.3 million.
This is almost the cost of the house he was buying. However, only Sh500,000 had gone towards actually reducing his loan. The rest, i.e. Sh7.8 million, was interest to the bank. Money that carried no benefit for him.
At this point if you have any loan, I suggest you do what James did and immediately call your bank to find out what you still owe them.
You just might be a bit surprised that in spite of your regular monthly repayments your loan balance has not decreased by much.
James, like many of us, did not understand how loans work. He is being charged 16 percent in interest every year. 16 percent of Sh10 million is Sh1.6 million a year.
To use or not to use a foreman for house construction
If we average this out into a monthly rate it would come to about Sh133,000 per month. This means a large portion of his payment is going towards interest and not necessarily cutting back on the loan.
James found out that when he started paying his mortgage, only about Sh6,000 per month was going towards cutting back on his loan and the remainder was servicing interest.
Definition of bad debt
Had James not realised this and continued paying his loan as is for the remainder of his mortgage, he would have paid Sh23.4 million in interest charges alone.
This is in addition to the Sh10 million he initially borrowed otherwise known as the principal. His house would have effectively cost him Sh33.4 million and not Sh10 million.
In other words if, after completing his mortgage, he decided to sell his house, he would only make a profit if he sells for above Sh33.4 million.
James’ figures may be large because his loan was specific to a house, but other loans also work in the same manner.
If you take a five-year car loan for Sh1 million, after those five years you will have paid another Sh500,000 in interest, bringing the actual amount you buy it for to Sh1.5 million.
A car is a depreciating asset, so you will have made a financial loss. This is called bad debt. Good debt enables you to acquire or do something that gives you a return over and above the cost of the debt.
So what should James have done, and what he can still do? Yes, we all wish interest rates were lower but that is not something we can control.
I like looking for solutions that I can do something about. His mortgage and most loans work on the principal of reducing balance, which we can all use to our advantage.
Every month, the interest is calculated on the basis of the part of the loan that is still outstanding. Let me use the car loan example to explain this further.
The total monthly repayment on that car would be Sh25, 000. Out of this, Sh15, 000 is interest – the bank’s money. Sh10, 000 is what is going towards repaying the loan.
Be clever about debt
After the first payment our outstanding loan would be Sh990, 000. Interest in the second month would be charged on that Sh990,000; the interest will recude and more of the monthly repayment will be applied towards the actual loan amount.
So James can start putting extra repayments towards his principal. If he had paid an extra Sh10,000 per month he would have cut his total interest down from Sh23 million to Sh15 million and he would pay off his mortgage in 14 years.
If he had put Sh20, 000, interest costs would be Sh12 million and mortgage completed in 12 years. Well, James now knows what to do.
He has decided to finish paying off this loan within the next five years. He will start putting an extra Sh25, 000 per month and increase this amount by at least Sh10, 000 every year.
If you have a mortgage or any other loan, just be clever about it. Put extra payments towards the loan and you will pay it down faster and reduce your overall interest costs.
Ensure by writing your instructions to the bank that your extra payments are applied towards the principal.
BY WACEKE NDUATI-OMANGA
