So you’ve just been offered a loan, but you can’t quite decide between two options:
- a 2 year loan at a higher interest rate or
- a 3 year loan at a lower interest rate?
Take Paul for instance…
He needs R20, 000 as in yesterday. His credit’s been approved but the consultant offered one too many options. He could loan the R20, 000 as follows:
- 2 years at 25% per annum or
- 3 years at 20% per annum.
20% per annum over 3 years sounds like the way to go, right? Well, let’s take a look.
Option one – a 2 year loan at 25% interest p.a.
Here’s how the conversation runs in Paul’s head:
“I’m not happy about the 25% per annum bit. Why couldn’t they offer me 20% like they did on the second option? Let me grab a calculator and find out which is best for me.”
“They’ve given me the go-ahead on a R20, 000 personal loan over two years. At a 25% interest rate it means I’ll have to repay R1, 067.43 every month.”
“R1, 067.43 per month times 24 months means I’ll have to repay R25, 618.32.”
“Okay, so that’s R5, 618 the bank makes out of me – about a quarter of the amount I’m lending. Sounds expensive; let me check out the second option.”
Option two – a 3 year loan at 20% interest p.a.
“Okay, cool. At 20% I’ll have to repay R743.27 every month. That’s R250 a month less than the first option which helps.”
“R743.27 per month times 36 months means I’ll repay R26, 757.72.”
“So the bank makes R6, 757. That’s about a R1, 000 more than option one. Okay, it’s going to cost a bit more but not by much. I’m going to go for this option. At least my repayment is cheaper on this option.”
What are we to conclude?
In an ideal world two things would happen:
- We’d loan the money for as short a time as possible
- We’d be offered the lowest interest rate possible
The truth is that lending someone money is risky. The fewer guarantees a lender has of getting their money back, the higher the interest rate the lender will ask.
In the example above, Paul was willing to trade off paying back a bit more in exchange for less impact on his monthly cash flow. Truth be told, option two is the better option, especially if Paul was willing to save the R250 difference between the two options, and settle the debt early.
If statistics are anything to go by, this won’t be the case. Paul will quite probably make more debt elsewhere.
Take the guy buying a new car:
- He’s already decided what car he wants.
- His bank is unwilling to negotiate on interest rates.
- To make the repayment fit his budget, he is forced to extend the finance term from 60 months to 72.
- On top of that he opts for a balloon repayment at the end
- After 60 months his motor warranty is up and he’s looking to trade. Only problem is, he still owes 12 instalments and a balloon repayment.
Sound like anyone you know?
When buying on credit do two things:
- Look at the amount you’re wanting to borrow
- Compare that to how much you’ll end up paying
Then say: “Let me sleep on this.”
Often you’ll find you’ve changed your mind by the next morning. But if that’s not the case then by all means go ahead and sign the dotted line.
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Until next time.
The InsuranceFundi Team