Avoid Debt Traps from Loan Sharks: Understanding Interest Rates
Beware!
Watch out! That interest rate is a debt trap. There’s no better way to state it
than to act the part of a watchman on the tower who should—in the loudest
voice—alert the city to impending danger and doom!
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But
why the interest rate, you may ask? Why should an interest rate be the cause of
a debt trap?
Perhaps
you have taken a loan before, or you are planning or considering taking one.
This time, I’m not referring to loans from regular banks that we are all
familiar with, but rather from various non-bank loan merchants or retailers
operating outside the banking system.
Of
course, there are many loan retailers around town (in Nigeria) now who are
willing to lend you money without the stringent conditions commercial banks are
known for. Similarly, there are loan apps that allow you to access loans simply
by downloading the app and making a loan request through it. With these
options, accessing loans for domestic purposes—such as purchasing electronics,
meeting urgent expenses, paying children’s school fees, or other reasons—has
become easier, better, and faster.
However,
take note: if you don’t pay close attention to the interest rate (and the
resulting interest amount) and ask pertinent questions about it, you may find
yourself on the path to the murky and gloomy land of indebtedness. Your
situation will then be no different from a person stuck in quicksand,
struggling to free their legs but sinking deeper instead. This is a reality I
have witnessed firsthand, as I know people who failed to consider this and,
even after more than three years, are still wallowing in a cesspool of
debt.
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The
internet age and the widespread deployment of information technology have
spurred the rise of many online moneylenders, especially in Nigeria. Currently,
the country has online moneylenders such as Zedvance
Limited, KwikPay, SnapCredit, CreditVille
Limited, SpartaCapital, and so on. Similarly, outside the
internet world, there exists a plethora of other loan providers. While they all
claim to have your best interests at heart, their loan terms—especially
regarding interest amounts—can lead to financial strangulation for the
unwary!
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Today,
however, I’m not here to inform you of the best among these options but rather
to help you “shine your eyes” so you can avoid monumental financial woes.
You
must be unusually wary of low lending rates (i.e., interest rates), especially
those specified in single digits by various loan merchants, both online and
offline. For instance, if the interest rate is 9% or below and the period is
not specified, you must be very careful. You need to ask whether the interest
rate is stated per month or per annum. If you’re told it’s per annum, ensure
this is clearly stated in the loan contract provided to you. Additionally,
monitor the loan interest calculations in the amortizationschedule to ensure they are strictly
based on the per annum rate and not calculated otherwise. If the rate is stated
per month, ensure the computations in the amortization schedule comply with
this term.
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Generally,
loan interest rates are stated per annum. However, with the proliferation of
moneylenders and online loan merchants outside the traditional banking system,
we now encounter situations where interest rates are no longer stated per annum
or calculated and compounded as such. Instead, we see lending rates on these
“soft loans” sometimes stated per month (not explicitly). If this were the only
issue and interest were compounded and calculated accordingly, this warning
wouldn’t be necessary. Unfortunately, the situation is such that some loan
providers calculate the interest amount on the outstanding loan balance every month
per annum, rather than compounding it monthly as expected. These moneylenders
often do this to increase their returns on loans, as a monthly interest
rate—even at a low single-digit rate—can result in an unusually high interest
amount.
Their
method, which contradicts standard lending rules, can be better understood
through an illustration.
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For
example, suppose a loan merchant gives you a loan of ₦100,000.00
on January 1, 2021, at 5% per month. Assuming no monthly repayments, what will
your loan balance be at the end of 2021?
Ordinarily,
the compound interest formula should be used to determine the loan balance at
the end of 2021. The formula is:
Amount = Principal * (1 + Interest
Rate) ^ Time
However,
to account for multiple compounding periods (i.e., 12 times a year), the
formula is adjusted as follows:
Amount = Principal * (1 + (Interest
Rate/Number of Compounding Periods)) ^ (Time * Number of Compounding Periods)
Based
on this formula, the loan balance would be:
Amount = ₦100,000.00 * (1 + (0.05/12)) ^ (1*12)
Amount = ₦105,116.19
This
amount, ₦105,116.19, should
ordinarily be what you repay at the end of 2021. However, with some loan
merchants, the amount you repay would be calculated as ₦179,585.63—a staggering additional sum
of ₦74,469.44, representing an
actual interest rate of 80%!
How
do these loan retailers arrive at this amount? Some of these loan sharks use
the following approach, as shown in the table below:
Table
1: Loan Amortization Table Using Loan Shark’s Approach
In
contrast, based on the scenario mentioned earlier, the amortization table
should look like this:
Table
2: Correct Loan Amortization Table
What
these loan sharks do is apply the interest rate (in this case, 5%) on the
opening balance of the loan each month without considering the principles
governing interest calculation and compounding over the relevant timeframe.
Even if a simple interest formula were applied, the interest for each month
should be calculated on the outstanding balance strictly for one month (i.e.,
5% * opening balance * 1/12), not 5% * opening balance, as this loan merchant
does. This explains why some clients of these loan sharks remain trapped in
debt despite their genuine efforts to repay. Many wonder why, after paying more
than 1.5 times the initial loan amount, they still have a huge balance to
settle.
As
shown in Table 2, even with monthly compounding, the interest amount should
never be this high. Therefore, what these loan sharks do is not only outside
the bounds of standard interest calculation principles but also a sheer
rip-off. At times, I wonder if this isn’t outright fraud.
My Personal Experience
I
once had an experience in this regard.
There’s
a moneylender patronized by some staff members at my workplace. One day, I
decided to approach this lending outfit, whose name I will refrain from
mentioning. I made the necessary contacts, and since I was well-known to the
wife of the man who established the organization, the process was smooth and
fast. Within a day, my loan was approved, and the amortization schedule was
sent to me.
As
I reviewed the schedule, I realized that the interest rate specified at 8% per
month was not calculated according to standard interest calculation principles.
Instead, the interest amount was calculated at 8% for each month, rather than
8% per annum divided by 12 months (approximately 0.67% per month).
At
that point, I understood why many lower-level staff at my organization were
struggling under the weight of debt from this moneylender. When they obtained
the loan, their only focus was that the rate (8%) seemed low. Unfortunately, by
the end of the repayment period, many were unable to meet the loan principal
repayments. The agreement with the lender allowed deferring principal
repayments, but the interest had to be paid monthly. After two years, many had
paid around ₦120,000.00 on an initial
loan of ₦100,000.00, only to discover
they still owed the full principal amount of ₦100,000.00.
How
pathetic and disconcerting!
Takeaway: Shine Your Eyes
In
conclusion, situations often arise that require immediate financial outlays,
and the most accessible source of funds for such needs is often a non-bank loan
retailer or a loan app. If you must go this route, the rule is simple: ask the
hard questions about how the interest amounts will be calculated under the loan
agreement. Even if you are provided with a loan schedule, ensure the interest
amount is computed according to the correct interest principles mentioned
earlier. You may also seek help from someone with a finance background to
interpret the amortization schedule.
The
timing of interest calculation or compounding significantly impacts the total
interest amount. Note that an interest rate of 10% stated per annum and
calculated as such will not yield the same interest amount as the same rate
stated per month, even with the same principal amount. Additionally, a loan
provider might state an interest rate per month but calculate the interest
amount by applying that rate monthly instead of spreading it over a year by
dividing it by 12.
A
word is enough for the wise. Watch out! That interest rate could lure you into
a debt trap.
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