Understanding How Lenders Make their Money
I bought my first property in 2015, and before that, I had done a lot of homework being in banking at the time, spoken to my colleagues and understood a lot about the financial implications of my decision, both in the short term as well as the long term. My pre-agreement statement and quotation stated that the interest portion alone of my R1 002 800 loan, would be R1 283 585 over the twenty-year period of the agreement. This meant that I would have paid R2.35m in total for the term of the loan.
What is interesting, but not entirely surprising in this scenario, is that my interest payments would have been more than double the amount I borrowed, and here is where the lesson lies in understanding how lenders make their money, and remain in business.
Lenders understand the power of COMPOUND INTEREST, and so should all of us. When repaying a loan, which is often monthly, a portion of the instalment is a payment towards the amount borrowed and the other portion is interest. An amortisation schedule can show you the split between capital and interest at any given time during the term of the loan. Even though the schedule calculates the interest amount for you, it is important to know how it is calculated.
What is COMPOUND INTEREST?
“Compound interest” (or compounding interest) is the interest on a loan or deposit calculated based on both the initial principal and the accumulated interest from previous periods.” - Investopedia. This simply means that you pay interest on top of interest.
Simple interest, however, does not compound, meaning that an account holder will only gain interest on the principal, and a borrower will never have to pay interest on interest already accrued.
To demonstrate a compound interest calculation, which is the method used to calculate interest, I use my home loan as an example for ease of reference on my YouTube series for loan interest calculations. The interest rate was 9.65% per annum over 20 year period.
Day one of interest, using both simple and compound, is calculated as follows: (R1 002 800 x 9.65%) /365 days = R265.12
On day two, the simple interest calculation does not change, as interest is calculated on the principal amount for the duration of the loan.
With compound interest however, the R265.12 is added to the principal amount to calculate interest on day two. This is calculated as follows:
(R1 002 800 + R265.12) x 9.65% /365 days = R265.19. Interest in now calculated on a higher amount every day until a repayment towards the loan is made. Do you notice the 7c difference between day 1 and 2?
Day 3 capital is R1 003 330.32 and interest is R265.26, Day 4 capital is R1 003 595.59 and interest is R265.33, etc.
These may seem like small differences, but they add up to thousands and thousands of Rands depending on the size and term of the loan. A huge lesson in these calculations is that the amount of interest you will end up paying depends on the day you choose to make a repayment and the amount that you pay. Paying more than what you are required to reduces interest. YOU HAVE THE POWER TO CONTROL THE AMOUNT OF INTEREST THAT YOU PAY.
So, if you miss a payment or request a payment holiday, the interest due will be added to the balance and the interest for the payments thereafter will be calculated on the new balance. This also applies to the “buy now and pay in 3 months’ deals”, as well as balloon payments.
Always remember, lenders are there to maximise profits like any other business, so when a payment break may be convenient for you, the lender does not take a break in charging interest, compound interest for that matter.
The good news though is that savings and investment accounts also attract compound interest, therefore you can create your own bank by saving your own money, borrowing from your own money when you need to and paying yourself back like you would to lenders.
About the Author
Makgaje Setlalentoa aka Makgaje The Money Buff created a YouTubes channel to feed the desire to improve her viewer’s quality of life through sharing her knowledge and experience in finance. Her educational background; experience in Private Banking inspired her deep passion for personal development, wealth creation and the continuous development of the African continent.
She majored in Statistics, Economics and; Money and Banking in her undergraduate studies and also completed a Honours in Economics. She was a Private Banker for the last four years she worked in corporate and, in 2015, was awarded Private Banker of the Year in the Johannesburg Area, South Africa. The primary goal of private banking is to create, maintain and preserve wealth. Everybody deserves this knowledge from the first Rand, Dollar, etc earned. Her objective is to provide unbiased financial knowledge to empower consumers to make better financial decisions.