Interest Rate

 

"An interest rate is the rate at which interest is paid by borrowers for the use of money that they borrow from a lender. Interest rates are normally expressed as a percentage of the principal for a period of one year." – Wikipedia

"The amount charged, expressed as a percentage of principal, by a lender to a borrower for the use of assets. Interest rates are typically noted on an annual basis, known as the annual percentage rate (APR). When the borrower is a low-risk party, they will usually be charged a low interest rate. If the borrower is considered high risk, the interest rate that they are charged will be higher." – Investopedia

A few key points to note:

• Expressed as a percentage of principal
• Noted on an annual basis
• Low risk, low interest
• High risk, high interest

Interest rates are always quoted in percentage form i.e. 8% p.a. P.a. stands for per annum which means that the loan carries 8% interest charge annually. So if you borrow only for half a year, the interest that you pay will only be 4%.

Some of you may wonder why you need to know all these. This knowledge will enable you to determine whether the debts that you have now is good debt or bad debt.

Some small business owners in my home town like to borrow money from unauthorised lender. They will borrow $1000. Everyday, the lender will collect from them $13. Since they deal with cash business, $13 per day is a small amount to them. After 100 days, they will borrow $1000 again and this will go on and on and on. Is this a good debt?

Let's do the math shall we? $13 x 100 days = $1300. That is 30% interest every 100 days! If we were to convert that to annual interest rate it will be a whopping 109.5%!!

Now you know why the ignorant gets poorer and the unscrupulous gets richer. You can't blame the opportunists fully when you are so happy in your ignorance can you?

Compare that with what the bank charges. You can get personal loan (no guarantor or collateral required) for 14% - 42% per annum. If you are a Government servant, you can get it for as low as 6.04% per annum!

You can do the comparison of the personal loans offered by Malaysian banks here: http://www.imoney.my/personal-loan

This is where I would like to draw your attention to the last two key points below:

• Low risk, low interest
• High risk, high interest

This is why you need to have a good credit standing. This is why I emphasise paying your debts on time every time. Generally the loans offered by the banks will have a range of interest rates. For personal loan above the range is between 14% - 42% p.a.

If you have a good credit standing, the bank that offers 14% p.a. will be happy to accept you as their customer. If you have a lousy one, even the bank that offers 42% p.a. will shut its door to your face. Then you will have no choice but to get the 109.5% p.a. loan.

Can you see the difference? Ignorance will cost you money. Your lackadaisical attitude will have serious repercussion.

Another thing to be aware of is the quoted interest rate may not be the real effective rate. In Malaysia, this normally applies to car loans and personal loans. This type of interest rate is called flat rate.

A flat interest rate is an interest rate calculated on the basis of the stated initial principal amount of the loan irrespective of the payment plan.

Let's say you borrow a car loan of $60k at interest rate 3% flat for a loan period of 5 years.

How the bank calculate the interest: $60k x 3% x 5 years = $9k.

Total debt is now $69k. Monthly instalment will be $69k/60 months = $1150.

The bank will charge you the full interest amount of the initial loan even though the debt is reduced over the years. Is this a good debt or a bad debt?

To do the comparison, you need to know the effective interest rate. As a general rule, flat interest rate is double the effective interest rate. In this case the effective rate will be around 6% p.a. Is it a good debt or still a bad debt?

Flat interest rate have been outlawed in developed countries. However, they persist in many developing countries, and have frequently been adopted by microcredit institutions.

If you were to go on the link I provided above, you can see that the flat rate of 7.62% is equivalent to an effective rate of 14% p.a. So be mindful of this when you do your opportunity costs analysis.

Lucky for us that for our single most expensive purchase, the housing loan is quoted in effective interest rate. You need to be aware however, whether the loan is of daily rest or monthly rest basis.

I know it may seem tough to know all these finance stuff, but it is really not that difficult.

Below is a simple diagram to explain the difference between daily and monthly rest. Outstanding loan on 1st April is $100k. You made capital repayment of $30k on 20 April.

 

If your housing loan is on daily rest, then from 20th April onwards your interest calculation will be based on the outstanding loan of $70k.

If your housing loan is on monthly rest, from 20th to 30th April you will still be charged interest based on the outstanding loan amount of $100k even though you have paid $30k on 20th April.

Not that difficult right? So be aware of this small detail before you sign on the dotted line.

With a myriad of offerings by the banks and the banking sectors constant innovation, it is quite impossible for me to cover everything in this book. Do some researches before you commit yourself.

Sometimes they hide the "interest" element under terms like "profit sharing", "admin costs", "exit penalty". So be mindful of those hidden charges when you do your analysis to determine whether the debt is good or bad. Have fun!