When a client requests a loan or line of credit from any financial entity (bank, finance company or cooperative), sums must be paid as interest rate.
It is important to point out that numeral 28 of article 3 of the Banking Law establishes that “interest” is ‘the sum or sums that in any firm or under any name are charged or paid for the use of money’. In Panama, there are three different methods or ways to calculate the interest and bills to be paid on a loan that is signed with a bank.
These three methods are:
Added interest: is the interest that will be paid over the course of the loan and is added to the original amount of the loan. This total is then prorated based on the number of payments the loan will have.
Discounted interest in advance: it is the calculate interest that the loan will pay in its useful life and is subtract from the original amount request. That is, much less is receive than is require.
Interest on balance: is the interest pay for the amount owe at the time the payment is make. It is the one that benefits the user the most, since the effective interest rate is lower. This method is the most used mostly by banks. For a clearer explanation, we will proceed to use the three methods, based on the following information:
A client requests a loan for B/.4,600.00; the interest will be 12% per year (1% per month); its term is 6 years with monthly payments (72 monthly payments). The bank will charge a 5% closing fee and an additional B/.400.00 is need for payments to third parties (insurance, legal expenses, others).
Let’s look at each of the scenarios:
Scenario No. 1: Added Interest
Requested amount = B/.4,600.00 + B/.400.00 = B/.5,000.00
Monthly bill = B/.5,000.00 + (B/.72.00 * 0.01 *B/.5000) = B/.125.73
(72*(1-0.05))
The total amount of the loan will be equal to: B/.125.73 * 72 = B/.9,052.56
Now we calculate the interest paid, the closing fee and the net amount you will receive:
Closing commission = B/.9,052.56 * 0.05 = B/.452.63
Interest = B/.5,000.00 * 0.01 * 72 = B/.3,600.00
Net receivable = B/.9,052.56 – B/.3,600.00 – B/.452.63 – B/.400.00 = B/.4,599.93
For the calculation of the effective interest rate (TIE), all the interests, expenses and commissions that the financial institution collects and retains for itself are take into account. Expenses and commissions for third parties are not take into account. For this particular case, the TIE is 22% per year, since the term, the monthly bill and the net amount to be receive without payments to third parties were take into account. What would change are the payments to third parties, but this does not affect the TIE but rather the cost of the loan, which in this case will be 25.6%.
Scenario 2: Interest discounted in advance
In this scenario, the procedure to obtain the total amount of the loan financed by the closing commission and with payments to third parties is as follows:
1 * 72 = 72 (monthly interest rate is multiply by the number of monthly payments)
72 + 5 = 77 (add the total before the closing fee)
100 – 7 = 23
100 / 23 = 4.347826 (the factor that will be equal to 100 between the previous result is calculate)
Total requested amount = B/.4,600.00 + B/.400.00 = B/.5,000.00
Obligation amount = 4.347826 * B/.5,000.00 = B/.21,739.13
Now we calculate the interest pay, the commission and the net to be receive:
Interest = B/.21,739.13 * 0.01 * 72 = B/.15,652.17
Closing commission = B/.21,739.13 * 0.05 = B/.1,086.96
Net to receive = B/.21,739.13 – B/.15,652.17 – B/.1,086.96 – B/.400.00 = B/.4,600.00
The net you will receive matches the amount we need, so the calculations are correct.
Monthly bill = B/.21,739.13 / 72 = B/. 301.93
For the calculation of the effective interest rate (TIE), as with the previous method, all the interests, expenses and commissions that the financial institution collects and retains for itself are take into account. Expenses and commissions for third parties are not take into account.
For this method, the effective interest rate (TIE) is 71.3% per year and the cost of the loan rises to 77.9% because there are payments to third parties.
Scenario 3: Interest on balance
According to this method, the monthly payment to be paid is calculated based on a compound interest financial formula.
We must first calculate the amount you will request, taking into account the closing fee and payments to third parties.
Amount to be requested = B/.4,600.00
The closing commission of 5% will be finance and there are payments to third parties. In this case, the amount requested and the total amount of the obligation will be B/.4,600.00.
Closing commission = 0.05 * B/.4,600.00 = B/.230.00
Amount received = B/.4,600.00 – B/.230.00 – B/.400.00 = B/.3,970.00
Letter = 〖B/.4,600.00 +( 0.01 (1.01))/(〖(1.01)〗^72-1)〗^72 = B/.89.93
Interest paid = B/.89.93 * 72 – B/.4,600.00 = B/.1,874.96. For purposes of explanation, the calculation of these interests was make, but these are neither add nor discount to the loan, but are charge on the balance of the loan.
The effective interest rate TIE for this case is 14%, but the cost of the loan rises to 18% because there are payments to third parties.
Scenario 3: Interest on balance
According to this method, the monthly payment to be pay is calculate base on a compound interest financial formula.
The results obtain by the “interest on balance” calculation method are better for the user than the other methods, since the interest is not discount in advance, nor add to the loan in the beginning, but is charge on the balance. of the loan; that is, the user pays interest for the amount owe at the time the payment is make. For this reason, if all the monthly payments are make, as agreed, the interest will decrease over time.
If we compare the amount of the monthly letter for a loan of B/.4,600.00, the “aggregate” method has an excess of B/.35.80 over the “on balance” method, on the other hand, the increase of the “discounted” method is by B/.212.00. This difference is in just one month, that is, after six years the person will have paid B/.13,777.21 more in the “discounted” method. In the “aggregate” method, the excess payment would be B/.1,725.04 than in the “on balance” method.
The TIE changes depending on the method of calculating the bills used (this proportion may be lower or higher, depending on the nominal interest rate, even if we leave all other variables the same).
It is important to indicate that if the user cancels his loan in advance, he is entitle to a refund of interest in the added interest method and in the discounted interest method; on the other hand, the interest refund figure does not fit in the interest on balance method, since the bank does not charge interest in advance.
We recommend that banking entities comply with their obligation to express the effective interest rate in all loan contracts, in advertisements, so that the user has the opportunity to decide for a loan with a low effective interest rate and, therefore, the total loan amount.
