Saturday, April 5, 2008

Guide and understanding loan rate

Recently I received a letter from UOB offering interest free loan package. It is so called interest free because there is no mention of interest rate in the package. Actually there is a hidden rate and it is not known to the borrower. Just like any other banks, instead UOB charges a one time processing fee of 3%, 5%, 7% and 9% for a 6-month, 12-month, 18-month and 24-month instalment plan respectively.

The table below shows an illustration of how your monthly instalment will be for the various loan amount and tenure:
Loan Amount = $5000 Tenure
24 months18 months12 months6 months
Payment per month $227$297$438$858
Total payment at end of tenure $5,448$5,346$5,256$5,148
Loan Amount = $10000 Tenure
24 months18 months12 months6 months
Payment per month $454$594$875$1,717
Total payment at end of tenure $10,896$10,692$10,500$10,302

Now the question is what is the actual interest rate that you are incurring? In the first part of this article I am going to guide you on how to make use of excel RATE function. We shall take an example for a loan amount of $10000 and 24 months tenure of payment.

Step 1: Open a new excel worksheet and click on any cell. Then click fx -> select Financial in category box -> select RATE -> click OK
If you can't find XIRR function, do the following steps:

  1. On the Tools menu, click Add-Ins
  2. In the Add-Ins available list, select the Analysis ToolPak box, and then click OK
  3. If necessary, follow the instructions in the setup program

Excel insert RATE function


Step 2: When a function arguments window pops up, type the following values:
Nper = 24 -> since it is a 24-month instalment and you are paying monthly, this is the number of payment periods
Pmt = -454 -> monthly payment in negative because it is cash outflow
Pv = 10000 -> this is the loan amount taken
Fv = 0 -> you need to pay until the balance is 0
Type = 0 -> assuming payment is payable at the end of every month
Guess = 0.1 -> assuming rate is at 10%

Excel RATE function arguments

Step 3: Computed result is shown as 0.00698 (you need to change format of cell) or 0.698% per period. In this example a period is one month. Therefore the actual or effective interest rate turns out to be 8.376% per annum.

As you can see from this example, a one time processing fee of 9% turns out to be at a rate of 8.376% per annum. No wonder the banks choose the former method to illustrate loan to consumers in order to make it more attractive.

I have computed a summary of interest rates for the rest of the loan amount and tenure in the table below. It is interesting to see that a shorter tenure actually resulted in a higher effective interest rate.

Loan Amount = $5000Tenure
24 months18 months12 months6 months
Rate per month0.698%0.714%0.777%0.840%
Rate per annum8.378%8.568%9.320%10.078%
Loan Amount = $10000Tenure
24 months18 months12 months6 months
Rate per month0.698%0.714%0.759%0.857%
Rate per annum8.378%8.568%9.105%10.281%

So I hope after reading this article, you will be better informed when dealing with loans in future. Most importantly you need to also calculate the actual or effective interest rate per annum and compare among the various options before deciding. So it is not fair to decide based on the total amount of payment at end of tenure alone.

2 comments:

Ku said...

A loan of 10k for a tenure of 24 months and payment of $10896 at end of tenure translates to 8.378% per annum? Hmm, if 8.378% p.a. then the total interest paid should be 10k*8.378%*2=$1,675.60 rite? But we are paying $10896 instead of $11675.60. Is there anything wrong with your calculation?

Mike Dirnt said...

no ku you cant compute it that way. remember the interest is on the balance of the reducing principal amount. for example 1st month is 8.378%/12 x 10k = A, then 2nd month is 8.378%/12 x (10k-A).