As medium-term financing becomes more readily available, particularly in the case of auto loans where the standard repayment period is five years or 60 months, it is always good to know how much you are actually paying in interest cost. Typically, most banks and financing companies will quote you an add-on interest rate, which is the gross interest rate per year multiplied by the number of years of the loan.
This add-on interest is added to your principal loan amount and divided by the number of repayments, which is equal to your amortization. As an example, if your wanted to borrow P500,000 to buy a car for a period of five years, with an add-on interest rate of 10 percent per annum, the total amount you would have to repay back is the principal plus 50 percent, which is 10 percent multiplied by five, which is the loan tenor. This will amount to a total of P500,000 plus P250,000 for a total of P750,000. Assuming you have to make a monthly amortization payment, this will be a total of 60 months, which is 12 months multiplied by five years.
Therefore your monthly amortization is P12,500. While most consumers will not think too much of paying 10 percent, you have to remember that, as you pay down your principal every month, this 10-percent interest is still being applied to the original principal amount. The effective interest rate on the other hand is the true interest rate you are paying based on the outstanding loan amount calculated after each principal repayment is deducted from your outstanding loan.
Using my trusty HP 12C to calculate the effective interest, this comes out to 17.2737 percent per annum. This is really how much interest rate you are paying for availing of the 10-percent add-on rate. In comparison, when banks give you their interest rate on your savings account or time deposit you are being quoted an effective interest rate. So is this bad news for the consumer? Not necessarily, after all, the effective interest rates on credit cards and pawn shops are typically in the lower range of 3.0 percent a month, or 36 percent per annum.
The important thing is for the consumer to be aware of the effective interest rate they are really paying for. While many consumers tend to find low down-payment options appealing, what they do not realize is that they are actually paying more in interest, since the principal amount becomes larger. To minimize your cost, you really should minimize your loan amount and your tenor. It really does not make sense to keep money in your savings account or time deposit and end up borrowing more money from the bank or financing company. With savings or current accounts paying you as little as zero-percent interest rate and time deposits paying you no more than 2.0 percent less the 20 percent withholding taxes, it absolutely does not make sense to borrow money at 17.2737 percent.
Of course, if you don’t have the money to begin with, you will need to borrow as much as you can and have the longest repayment terms possible. In this situation, with an effective interest rate of 17.2737 percent, there is very little margin for missing out on making an amortization payment. I guess this is the primary reason that the highest auto-loan default rates are those that have the lowest down payments with the longest terms. In this case, before you get into trouble, you should ask yourself if you really needed that car so badly that you would be willing to take on such a risk.
Comments may be sent to georgechuaph@yahoo.com