Thank you for Caroline Green's article dealing with some of the serious problems
One aspect that requires further explanation is the understating of annual interest
rates that occurs when rates are quoted per month. A loan at interest of 5% a month
is not equivalent to an annual rate of 60% if the loan is repaid in monthly installments.
If I borrow $120 for a year at 60%, at the end of the year I return the $120, plus
60% x $120 = $72. I have bought the use of $120 for a year, at a cost of $72.
But if I borrow according to the "balloon approach" described in the article,
I am required to pay 5% of $120, or $6, at the end of each month, and to pay $120
at the end of the year. This is clearly more disadvantageous to me, because the cost
of the loan is still $72, but I do not obtain the use of $120 for a full year.
To find the real annual interest rate in this case, we need to regard the $6 monthly
payments as repayments of the principal. Then the final payment of $120 consists
of two elements: $72 in interest and the remaining $48 of the principal that has
not yet been repaid.
In this example, I have obtained, not the use of $120 for a year, but the use
of $120 in the first month, the use of $114 in the second month, the use of $108
in the third month, and so on down to only $54 in the twelfth month. Thus the real
amount of my loan during the year is not $120, but the average of the 12 monthly
figures, which comes to $87. Since I have paid $72 to obtain $87 for a year, my interest
rate is 72 divided by 87, or slightly less than 83%.
If the total repayment ($120 + $72) is made in equal monthly installments of $16,
the annual interest rate is of course even higher. In this case, the borrower obtains
the use of an average of only $32 for the year and pays interest of $72, so the interest
rate is 225%. Even if the so-called monthly rate is reduced to 3%, a loan repaid
in this way has an annual interest rate of 95.6%.
- Allen Myers, Phnom Penh