Cost of loan can be very confusing, I will try to make it less confusing. I have talked to a bunch of business owners and more than half of them end up more confused… that reminds me that am not exactly the best at tutoring.

I will use a simple example of a 10 million naira loan at 20% over ten years. Well, if we take a 10M loan at 20% then we would only have to deal with interest of 2M. Wrong. Unfortunately, that was the mind set of business owners that were confused about cost of borrowing.

Screenshot below is part of a spreadsheet I use in finance planning. 10 million naira loan at 20%, ten years to pay off means you would be paying over 13 million in interests only.

Now this is where it gets interest-ing. Most businesses (start-ups) do have negative cash flow for first 2 years of operation. The monthly payment for the loan in our example is only N193,256. At the end of 2 years (24 months) the business would have paid over 4.6M towards the loan. That’s almost half the principal borrowed. But the business would still be owing over 9.2M and that’s because only about 800k of the 4.6M paid is applied towards the reduction of the principal borrowed. See the row highlighted in yellow from screenshot below.

From table above you can see how much of your monthly payment actually goes to reduce your debt. Payment number 1 (first month) for example, you pay 193,256 but only 26,589 goes towards your debt. The balance of 166,667 goes away to your lender as interest. That’s about 86.2% of your payment. While the percentage of your payment that goes away to interest reduced as you make more payments, in this example, it takes the 79th month (6 years 7 months) payment before your monthly payment will be 50% towards your debt and 50% away to interest. See image below.
Did you notice that at the 6 years 7 months (79th payment) example above, you would still be owing 5.7M?

I hope the details behind loan servicing is clearer with this example and that it helps someone in decision making. If it helps just one person, am happy!

Should you make extra payments to reduce interest paid? That’s another question for another day.


LasBonBoi