Debt Trap – How loans trap us
The financial crisis is one inseparable part of a person’s life, and it may come in anyone’s life, without any notice. There are situations when the most financially stable person would seek support. Any they come at any time of our lives without notice.
That need for financial support is complemented by a loan, which could be a formal arrangement with the banks, financial institutions or informal money markets with individuals. The loans are either business loans, housing loans and the widely use loans are the personal loans.
When the credit is availed by the banks, other financial agencies and informal money markets for the personal use, it is called Personal Loans. This Personal Loan has come to the rescue of the many people, with the instant availability of funds. These Personal Loans have always been the helping hands during the urgent needs of the people and have solved various unavoidable circumstances in a person’s life.
But at the same time, the Personal Loan has been a cause of worry for many. Even, if the Personal Loans have been the lifesavers many times, they are the ones, which come with some hidden traps too
In Papua New Guinea, the desire for fast personal loans to patch the gap before the next payday has forced many people to turn to INFORMAL MONEY MARKETS. The main reason for this is the CONVENIENCE, quick turnaround and the ZERO paperwork that comes with the requests for a loan.
As always, convenience comes with a price, and the price for this informal money market is very high. The interest charge for these loans are usually between 30-60 percent and only for a short period usually within 1-2 weeks.
The formula used for this interest calculation is the SIMPLE FORMULA.
You borrow K1, 000.00 at rate of 40% for 2 weeks; you pay K1, 400.00 at the end of the 2 weeks. If you do not pay at the end of the 2nd week, they charge another 40% on that K1, 400.00 and you end up paying K1, 960.00 after a month.
These informal money markets has sadly been a DEBT-TRAPPED for many Papua New Guineans who were not able to pay their loan when the loan sharks come calling.
Then there is the Banks and the Financial Institutions who also offer personal loans aside from housing loans and business loans.
The requirements for personal loans, housing loans and business loans varies from each Bank and financial institutions. However, the calculation of the interest charge is the same across all those different requirements.
I will discuss the Housing Loan and how interest are charge, it is no different to a personal loan and business loan.
Personal loans have higher interest rates, Kina Bank charges about 20% p.a and BSP charges at about 27% per annum. Home Loans have lower interest rates. Kina Bank Charges 6.5% interest on home loans whilst BSP Bank charges 6%, however BSP has a special of 4% per annum for the First Home Ownership Scheme over a period of 40 years.
Let’s use the FHOS of BSP to do a calculation of K400,000
for period of 40 years at 4% per annum interest
These Banks and financial institutions use COMPOUNDING FORMULA to calculate interest payable and additional charge interest on any outstanding loans which the called CAPITALISATION. There 2 calculations, the first is for the repayment amount for the duration of the loan and the other is the interest charge on any outstanding loans. The interest is calculated daily and charge monthly.
- 4% annual interest rate needs to be change into an effective monthly rate. Therefore we divide 4%/12 months = 0.3% effective interest rate
- Number of repayments would be 40 years multiple by 12 months, therefore 40 x 12 = 480
- Calculating the Monthly repayment using the formula above gives you K1, 573.64 which is monthly repayment
- Aside of the fixed repayment, there is also an interest charged for loan outstanding. This interest is calculated daily and charged monthly, this charge is called CAPITALISATION.
A simple spreadsheet of repayment looks like this after calculations are done, it is done using a compounding formula
The BIGGEST TRAP in this Formal Loan is that the loan interest is charged daily and added to the loan amount monthly. This interest on loan increases the loan amount each month, and whilst we pay fixed amount monthly, the repayment would not seem to make any difference as CAPITALISATION costs keeps adding up.
The only way to get out of this formal debt-trap is that you find ways to pay more than then monthly repayment, any lump sum amount or extra repayments would assist in getting out of this, otherwise, it would take more than 40 years to completely pay of your debt.