Banks and financial institutions give out various loans to different customer categories. The three broad categories include check off loans, micro credit and formal business loans.
A check off loan refers to an arrangement where an employer has a written agreement with a financial institution to advance loans to its employees whose repayments are deducted by employer and remitted to the lender. They are popularly called personal loans. A micro credit loan is usually a short term loan given to informal business people and secured by house hold items and business equipment. Formal business loans are given to organized businesses for a longer period of time and secured by tangible collateral like land.
Each of the above loans has different risk profiles to the lender and is priced differently. The higher the perceived risk the higher the cost associated with the borrowing. For illustration purposes, let’s look at a customer borrowing kes 1 million for 12 months under each category to see the costs incurred until the loan is fully repaid.
Advanced as a check off loan, at the current interest rates of 20% on reducing balance, the borrower will incur the following costs; insurance premium of KES 4,226 and negotiation fees of KES 3,000. The monthly repayments are 93,002 which totals to KES 1,116,024. The interest paid is therefore KES 116,024 only. Assuming no other charges and penalties are levied during the life of the loan, total cost for this borrowing becomes KES 150,025 only. This translates to a cost of 15% of the loan amount.
Micro credit loans are quite expensive and hence no bank quotes an annual rate of interest. The rate usually ranges between 1.5% to 2.5% per month. One million repaid over 12 months attracts an interest of 2% per month thus the interest component of monthly repayments is KES 20,000. Other costs include insurance against death & total disability of the borrower as well as against fire and burglary for the items offered as security.
The premium depends on factors such as age and marital status. For a single borrower in their early 30’s, the premium is around KES 30,000. The bank will then charge a commitment/ appraisal fee of 2.5% thus deducting kes 25,000 from the loan proceeds. Legal paperwork related to security may cost about kes 1,000. In total, the costs for the loan are as follows; KES 240,000 in interest payments, KES 30,000 insurance, KES 25,000 appraisal fee, KES 1,000 for legal costs making the total spend of KES 296,000 or 29.6% of borrowed amount.
Formal business loans are usually secured by land title deeds. Over and above the interest paid and bank commissions, there are costs associated with valuation of the property and legal fees. A typical loan of 1 million repayable over 12 months will have the following estimated costs; KES 2,500 application fees, KES 25,000 appraisal fees, Insurance premium of KES 9,300, valuation fees of about KES 20,000 and legal fees of about kes 27,000. The total interest at an assumed rate of 23% is KES 124,000. This brings the total cost to KES 207,800 translating to 20.8% in expenses associated with the borrowing.
From the above it is clear that salaried people get the cheapest loans followed by formal businesses. The informal sector without tangible security gets the most expensive loans on offer.
Before you apply for a loan, think of how much it will cost and only proceed if it’s worth it.