Add on Rate

posted at Business Mirror (6/7/10)

http://businessmirror.com.ph/index.php?option=com_content&view=article&id=26129%3Aadd-on-rate&catid=28%3Aopinion&Itemid=64 

Add-on Rate

by Edmund Lao 

When we were in high school, we learned from Consumer Mathematics that when we place money in the bank, the bank pays interest. The interest is computed based on the principal or the average daily balance, rate of interest, and the time our money stays with them. Interest rates vary depending on the placement vehicle chosen. There are the savings account (passbook and ATM account), Time Deposit, Special Savings account, trust funds to choose from. There was a time when banks interest on time deposits even reached as high as from 16 to 20 % interest per annum even for a five thousand pesos time deposit. Nowadays, interest rates are very low. You can get a measly 3% interest if your money is at least 10 million pesos. The reason we were given interest is that the depositors apparently lent their money to the bank, which in turn use the depositors’ money to do business. In short, the bank is leveraging on other people’s money.

What the bank does with our money is to lend it out to clients and charge them interest for the said loan. And majority of the loan applicants are us, the depositors. Apparently, we are borrowing our own money and paying out interest to a third party. And worse, the interest being charged is higher than the one being paid to us. This is like killing our own cash, Instead of cash flowing into our pocket, cash flows out of our pocket and flows into the lenders’. That is primarily the reason they are rich and we are not. They were able to create money from almost nothing.  For illustration, let us use the table below  to show how money works:

Here we see that the same initial amount of money earns differently where the maturity depends on the rate of return as shown. Money works for us if we are earning from the given rate of return.  What if depositors put money in the bank that earns 4% while being in debt with the same at 12%? This will be a case of money working against us and it will make us slave by having us work for money. Assuming that the loan was paid after 36 years, the bank would have made 6M from the depositor. That would explain why the banks own assets such as properties and huge buildings that they rent out to tenants. That would also explain why borrowers are always deep in debt. They just do not know how money works. If they knew, they would not be in a financial mess.

There are different kinds of interest rate associated with loan. The most common is the Add-on interest being offered by the banks. Almost everyday, employees receive at least three calls from service providers that sell the idea of applying for Add-on interest.  What is Add-on interest and how does this work? By definition from Wikipedia, it is a method of calculating interest whereby the interest payable is determined at the beginning of a loan and added onto the principal. The sum of the interest and principal is the amount repayable upon maturity. For example, assuming you get a loan of 12,000 pesos payable within a year and with an interest of 1% per month. Normally, we think that 1% per month equates to 12% effective interest annually. This is where majority are confused. The principal is then divided by 12 to get the monthly payment of 1000 pesos. The interest is then computed as 12,000 x 1%, which yields 120 pesos. The total monthly payment is 1,120 pesos. In a year, the total payment is 13,440 pesos. If you compute the interest paid, you will be very happy to know it really is 12% per annum. The table below will show you otherwise:

As can be seen from the table, what was once thought to be 12% per annum is actually 37.24% which is thrice the original rate. The 12% effective rate is only applicable to diminishing balance method (DBM) of calculation. The add-on interest applies a fixed interest based on the initial amount of loan, No matter how small the balance is, the interest is still constant.

This kind of loan is a good example of how to slowly kill one’s personal finance. Consider being in this kind of situation, one would work harder just to be able hand over hard-earned money to the lender. Now when take-home pay is not enough, some of the negative effects are: too little time for family, stress, inefficiency in the workplace. Worse, some resort to theft of company time and money. The usual problem here is not that we do not have enough. It is just that we feel we do not have enough.

What if instead of paying the above interest, it was saved? Let us assume that a person aged 20 started saving the 1440 pesos yearly interest for forty years at the rate of 8% per annum, at the end of the term, he would have accumulated 5 million pesos!

If only people have the proper mindset and awareness when it comes to handling finances, these loans would not have been tempting to accept and people can build their wealth.

As the Bible says:

Proverbs 13:11  “Dishonest money will dwindle, but money gathered little by little will surely grow.”

Proverbs 22:7  “The rich rules over the poor, and the borrower is the slave of the lender.”