I wonder if consumers understand every detail of all the contracts they sign in with other parties such as financial services providers. Perhaps their understanding tends to be only based on mere explanation by the consulting parties for the commitment involved in any particular contract. As part of one of the module i have been doing this semester (Financial Accounting Aspects 4), i had the chance to have a better understanding of the true meaning of bonds and the commitments involved especially towards the consumer. After having a clear understanding of bonds, this question remained unanswered: “Are consumers really aware of the meaning of taking a mortgage bond from any money lending institution?”
I would like to assume that given the chance to fully explain to every consumer before signing of bond agreements would result in a considerable shift in the approach which consumers take towards bonds.
When consumers buy assets such as a house or a vehicle, the price cannot be paid in a single lump sum by an ordinary consumer. I am sure businessmen are among those who can afford this considering the ability of investors such as Warren Buffet who can pay a lump sum of $1 billion in cash. As a result, consumers have no better option besides approaching banks for mortgage loans.
An amortised loan is when the lender may require the borrower to repay parts of the loan over time making principal reductions (Firer, Ross, Westerfield and Jordan, 2004:167). According to the HP10bII Financial Calculator User’s Guide on page 67, amortisation is the process of dividing a payment into the amount that applies to interest and the amount that applies to principal.
These fixed monthly payments do not say anything towards the consumer who does not understand the financial jargon. However, all is revealed when every payment is split into ‘interest’ and ‘principal’ contributions – amortisation. Simply said, it is shocking to analyse all the payments paid over the entire duration as a consumer literally pays off a mortgage bond in the last few years of the bond. Payments near the beginning of loan contribute more interest, and less principal, than payment near the end of the loan. Amortisation clearly shows the payments are mostly made up of interest than loan payment in the first half (almost) of the loan repayment if the monthly payment remains unchanged throughout the period. This article will cover up in-depth insight of bonds.
This article will use an example of purchasing a house worth US$120 000 over an agreed period of 20 years. This is generally paid on monthly basis (payments) calculated by the bank at an agreed interest rate. From the above example, we shall assume 12% interest is charged per annum with a consumer not expected to pay any deposit. The loan provider is assumed to be Supreme Group Bank.
The following are the details for the loan. Take note that all the figures are rounded off to the nearest $1. This means that, for the loan borrow from Supreme Group Bank of $120 000, at an estimated interest of 12% p.a. payable over a period of 20 years, the monthly payments of $1 321 amounts to $317 112 [same as $1 321 X 12 months X 20 years]. The difference between the loan amount and the total monthly payments is pronounced as interest. Therefore, this loan attracted a loan interest of $197 112 which is 164% of the loan. Therefore, in this loan, the consumer would have saved $197 112 if the consumer had the ability to pay cash. This is expensive yet consumers are not aware of this i assume or they have no better option. If Supreme Group Bank could charge one client this amount of money over 20 years, how much could it earn if it had served a minimum of 1000 clients per year? Perhaps this could point out that this is one of the reasons why banks are very rich.
The overall contribution (total payments) of $317 112 is made up of an actual amount borrowed of $120 000 and interest amount of $197 112 which translates to 37.84% and 62.16% respectively. This is graphically presented below:
From the table below (above mentioned example) a further explanation is made on what really happen during the whole loan repayment period. The table shows how the monthly payments are split into ‘principal’ and ‘interest’ contributions throughout the loan period.
For example, the monthly payment of $1 321 had been split as follows, in randomly selected months within the loan repayment period:
The above table is graphically represented below:
From the above graph, it is clear that the interest forms the large portion of the monthly payments until during the 172nd payment (14 years + 4 months) when the principal contribution is almost equivalent to the interest contribution. However, the interest decreases towards the end of the loan period. This is because the interest is charged on the outstanding loan balance. That is why there is huge interest paid in the first month as the consumer owes the bank a huge amount yet very little interest charged during the 240th (last) period as the consumer owes the bank little amount.
The graph below shows the composition of the monthly payments (principal and interest – contributions) on every last month of all the years of the loan repayment.
The whole tabular presentation is shown below:
A comparison between amounts of annual payments, accumulated loan payment, loan balance and the accumulated yearly payment is plotted graphically below. From the graph, interest is indicated as the gap between the total payments (purplish line) and the loan payments (red line). On the other hand, the loan balance slowly decreases in more than the first half of the loan period and sharply decreases towards the end of the period.
The article has defined the amortised loan which seeks to simplify monthly payments which are split into principal and interest payments throughout the loan payment. These contributions have been compared and analysed throughout the loan repayment period. It has been identified that payments consists largely of interest in more than half of the loan payment period and sharply decreases towards the end of the loan repayment period. This has been identified as the most costly element towards consumers. From the example given, it was discovered that the interest was more than the loan amount and possibly contributes to the reason which banks and financial lending institutions are so rich.
In the first place, it was highlighted that consumers have no better option besides approaching the banks to increase their chances of purchasing assets. I, however, seek to provide an alternative cost effective option for consumers. Despite some financial lending institutions do not ask for a deposit from consumers, it seems to be affordable to consumers yet in actual fact more money is lost in interest as the longer the duration, the more interest paid. In the next article, i will discuss and present possible ways which consumers can make use of to minimise the cost of interest they incur. These include deposit payment and increase in monthly payments.
Firer, C., Ross, S. A., Westerfield, R. W. & Jordan, B. D. 2004. Fundamentals of Corporate Finance. Berkshire: McGraw Education.
Hewlett-Packard Company. 2007. HP 10bII Financial Calculator – User’s Guide. 2nd ed. Hp invent: San Diego.
Author: Lucky Sibanda is a Btech Business Administration (2013) student at Cape Peninsula University of Technology (South Africa). He is a seasonal blogger with interests in education development and financial aspects. Some of his articles are found on: https://ckisto.wordpress.com/ and http://supremeeducators.wordpress.com/