I hear, read about, and watch people complain about loans. In particular, they cry foul as even after repaying their loans for years, they realize that most of their payments just went to covering interest and that the loan balance had hardly moved.

Well, let’s go back to basic economics. People will sacrifice a benefit now in the hope of enjoying more benefits in the future. The same is true with lenders.

Borrowers need to understand that lenders are sacrificing the use of their money now (by lending them out) in the hope of having more money to spend in the future. And by the very nature of the loan amortization table, where periodic payments are fixed, interest is based on a diminishing balance of the loan. 

This means that interest is charged only on that portion of the original loan that remains unpaid.

What borrowers fail to also realize is that the lender does not earn the absolute equivalent of their quoted interest rate over the term of the loan.  

Say, the total loan of Php100,000 is repaid over one year, the total interest collected by the lender is only Php11,880 or 11.88% p.a. of the loan and not the quoted 21.25% p.a. Computing interest based on diminishing balance actually favors the borrower.

Now, if all loans are laid out in amortization tables with interest based on diminishing principal balance and lenders do not really earn the quoted lending rate, aren’t they losing money?

The answer to the question is no (assuming lenders keep their past due ratios in check and their cost of capital low). To earn their quoted rate, lenders must relend all principal and interest collections at the same quoted rate continuously. This requirement is quite easy to do in a country where loans are tapped into frequently.

But be wary because a lender may just try to minimize on the need to relend by jacking up their interest rates. Now, the question will be, “Won’t borrowers balk at the high rates?”  This is where lenders use behavioral economics or, in magicians’ terms, the sleight of hand. 

Lenders know that the brain is loss averse and taking on a loan with a high interest rate is immediately perceived as leading to losses. Conversely, contracting a loan with low interest rate would lead to a lot of savings (vs. loans with high interest rates).

Would you not be attracted if I told you that I can extend to you a loan that not only allocates more of your payment to the principal while charging a low rate of 0.99% per month over the same 12-month term? 

So, next time you borrow, don’t worry if most of your payments go to interest first as that is the equitable way of repaying loans. Focus more on the effective interest rate. And most important of all, think twice if you really need to borrow.