The true cost of loans

Do you know how much your loan truly costs? Why do we find ourselves strangled by debt, wishing we never took the loan in the first place? Because we did not understand the actual cost of the loan. If you have to borrow, you need to be smart about it.

Whether it is that credit card that we swipe to satisfy short-term shopping urges or that business loan that you took to cover salaries, or even the Sacco debt you took to buy a piece of land, you will have to factor in that you will owe the bank for giving you that money.

Let’s take Mike as our example. Mike wanted a new car, and had given himself a budget of Sh1.2 million. Out of this, Sh200, 000 would come from his savings and the rest he would borrow. That was four years ago.

HOW DEBT WORKS

Mike recently found out how debt works. He has now realised that he spent more than he actually wanted to. Mike has spent Sh1.6 million because the interest that was remitted to the bank as part of his monthly repayment also constitutes a cost for Mike. The car is now worth Sh700, 000. This revelation was not a welcome surprise, considering he had only wanted to spend Sh1.2 million. Had he known, he would have spent less or borrowed less; he could have saved more money than just Sh200,000 to put towards the car and then borrow less, or borrowed Sh700,00 and bought a cheaper car, and then spent Sh1.2 million inclusive of interest charges.

In order not to fall into the same trap as Mike, you must factor in the total cost of the money you are borrowing – interest included – and fit that into your budget. When you do this, you will think of your debt in a different way.  Maybe you will not swipe that credit card on that Sh10,000 item if you know that the item could end up costing you Sh14,000 that year (give or take, depending on how you manage your payments).

MISTAKES WITH LOANS

It’s not only in consumer decisions that we make mistakes with loans. Let’s say Nyambura buys a piece of land for the same amount of money as Mike’s car. She borrows the same Sh1 million at the same interest rate. She then intends to sell the land when its value has risen by Sh800,000. She reckons that’s a decent profit. Nyambura has done the right thing in setting a goal for her investment. The only thing is that she has miscalculated the true cost. The land actually costs her Sh1.6 million when you factor in the interest fees, and so her profit is halved. She will only make Sh400, 000 when she finally sells it.

Many people have done this and realised that they did not make as much money as they thought they would. Many others have made a loss due to this miscalculation.

So far, we have not included the other costs that come with borrowing. Processing fees can be anything from 1 to 3 per cent of the loan amount, depending on the bank and how you negotiate. If we assume they charge 2 per cent on the Sh1 million loan amount, that’s an extra cost of Sh20, 000 on Mike’s car and reduction in Nyambura’s profit by the same amount.

The good news is, once you understand your loan you can figure out how to reduce its costs. Borrow smart. Don’t go in with eyes wide shut, glued together by the excitement of what you are buying or investing in. Debt is not all bad but ignorant debt is terrible. Understanding the true cost will ensure that you are empowered in your decision making.

Waceke runs a programme on personal finance and entrepreneurship. To sign up, email her at [email protected]| Facebook/centonomy or go to www.centonomy.com