Wednesday, October 31, 2012

Difference between interest on BALANCE and on PRINCIPAL

OK, this came up because of an offer by Citybank... they were offering a loan through the credit card, at an interest rate of 2.72% pa... lower than fixed deposit, right? Arbitrage opportunity?

WRONG.

Because the 2.72% is based on PRINCIPAL, not on balance outstanding. There's a big difference. This means the effective interest rate is actually 5.44%, ie double.

Let me explain with a simplified example, why interest on principal loan is always higher than interest on balance.

Let's talk about a 2 year loan of 2 million, at 10% per annum, and installment is once a year.

For interest on balance, repayment schedule is:
end 1st year: repay 1million + 200k interest (10% of 2 million balance).
2nd year: repay 1 million + 100k interest (10% of 1 million balance)
interest=300k

For interest on principal.
1st year: repay 1m +200k interest
2nd year: repay 1m + 200k interest (10% of 2 million principal!)
interest 400k

So this citybank interest on principal loan is actually higher than stated.

BTW, the above example, it's only 33% higher because there's only 2 repayments, the difference becomes higher the more repayments are made over time.