Personal loans are pivotal in personal financial management, impacting cash flows significantly. It's estimated that at least eight out of ten individuals have availed themselves of a personal loan during their working lives.

Typically unsecured, these loans are obtained from banks or licensed financial institutions to fulfill personal needs such as paying for education, rent, or acquiring assets like cars, plots, or houses. It is worth noting that the structure of personal loans differs from jurisdiction to jurisdiction and from bank to bank.

Unfortunately, many individuals have encountered disappointments stemming from a lack of comprehensive knowledge regarding the structure of their loan agreements. Often, consumers focus more on the amount and timing of disbursement rather than understanding the other intricacies of the loan. This article aims to provide clarity by elucidating the essential terms and structures, empowering consumers to make informed decisions about their personal loan contracts.

Interest rate and other charges

Interest Rates: The primary cost associated with borrowed funds is the interest rate, typically expressed as a percentage per annum (year) (BOG Notice No. BG/GOV/SEC/2021/12). The Bank of Ghana prohibits financial institutions from quoting interest rates per month. For example, if the interest rate for a personal loan is say 30%, then it is 30% per annum (year). So the next time a financial institution tells you its interest rate is 5% per month, just multiply the 5% by 12 months to get it expressed in per annum format, and in this case it would be 60% per annum. Consumers often get confused to think that 5% per month is far lower than say 30% or 40% per annum. It is this seeming confusion that necessitated the Central Bank’s prohibition of monthly quoted interest rates. The interest rate is the main cost because it runs with the tenor of the facility.

Normally the interest rate will vary from bank to bank but it is stated as the GRR (Ghana Reference Rate) usually plus a margin depending on the risk profile of the customer in question. Ghana’s personal credit scoring system is not well developed and therefore hardly is the individual priced based on his or her risk profile. However, you could be denied a loan if you have a bad personal credit record checked through the credit reference system. Banks or licensed financial institutions normally price according to products or sectors/segments.

Other charges:  Charges such as processing fees, facility fees, management fees, insurance, etc, contribute to the overall cost of the loan. While consumers tend to focus solely on the interest component, it's crucial to consider these ancillary charges, which remain constant regardless of the loan tenure.

Often times, customers make their calculations with only the interest component and therefore most enquiries about personal loans costs are centered on interest rates. It is important to note though that the other charges are upfront payments and do not travel with the tenure of the facility. For instance, if a processing fee is 2%, it does not matter whether the facility is contracted for a year or six (6) years it remains same for whatever tenure the customer chooses or qualifies for.

It is important to note that bargaining power of consumers is low when it comes to personal loans pricing. As an individual, you may not be able to negotiate personal loan pricing as advertised by a financial institution. The only time you may be able to negotiate the price is when you approach the financial institution as an organization or a group. The group dynamics make it possible for the financial institution to accede to a concessionary rate request because certain conditions may be fulfilled to reduce the risk associated with the request.

Rate type

Understanding the type of interest rate offered is paramount. Loans can feature either fixed or floating (variable) rates. Fixed rates remain constant throughout the loan term, providing stability amidst fluctuating economic conditions. Conversely, floating rates fluctuate, potentially impacting monthly payments. It's essential to inquire about the rate type to anticipate potential changes in repayment amounts.

In certain instances, the financial institution applying a floating rate may not apply the applicable increases which may push customer’s deduction up but use the difference to extend the tenure for the customer and therefore customer may not finish according to the initial tenure given. A lot of customers complained that they would not normally finish according to the initial tenure; if this is so and you have not skipped repayment, then you might have signed on to floating rate and just not to distort your monthly cashflows, the lender in question would extend your tenure with the difference. The fixed rate provides some comfort during a period of rising rates as incomes do not increase as frequent as interest rates and the taker has the advantage of refinancing the outstanding balance when rates take a downward trajectory.

Method of interest rate application

I have encountered customers attempt to calculate the interest applicable based on the interest rate given without they knowing the method of application. Generally, there are two primary methods that dictate interest calculation, simple interest (flat rate) and reducing balance (amortization) methods. While simple interest disregards monthly repayments, reducing balance considers decreasing principal amounts over time, resulting in diminishing interest. Using the correct method ensures accurate calculations and avoids financial discrepancies. I have noticed that, some customers attempt to calculate interest using simple interest any time an interest rate is given without knowing the method of application. So, don’t just ask for the rate, ask for the method of application as well. It is important to note that for the amortization calculation, one may need a spreadsheet to be accurate or standard formulae.  

Maximum qualifying amount

Consumers are usually interested in how much amount of loan they qualify. Financial institutions determine the maximum loan amount based on set parameters or an individual's total personal emoluments. While some institutions impose fixed limits, others assess eligibility based on income. Understanding how loan amounts are determined helps manage expectations and ensures realistic borrowing limits. In a nutshell, how much you qualify for is a function of your total emoluments, the maximum tenure allowed, set debt service ratio (DSR) and the rate of interest applicable.

Even though personal loans are unsecured, that is, borrowers are not required to provide a tangible security; the salary of the customer is the underlying security. Some banks or lending institutions however may require tangible collateral beyond certain limit specified by them.

Tenure

Personal loans would be contracted within a defined period called tenure. The maximum allowable tenure may fall between a month to about 96 months (8 years) depending on the lending institution. However, in the case of mortgages, the tenure could be more. The tenure is very important because it is a determinant of how much you can qualify for and it also affects how much you are expected to pay as monthly repayments or instalments. Longer tenures yield lower monthly installments but incur higher total interest costs. Financial institutions calculate Equal Monthly Installments (EMI) - that is, the amount payable monthly by the borrower which is inclusive of interest and principal, based on the agreed tenure, adjusting for fixed or floating rates. For a fixed rate, the EMI is supposed to be the same until maturity but for a variable rate the EMI could go up or down based on money market rate fluctuations.

Debt Service Ratio (DSR)

There are instances where customers will want their entire salary (thus %100 salary) to be deducted as monthly loan repayment. However, it is important to note that your bankers would not allow a 100% deduction of your salary, so normally what is known as a DSR is established and it varies from one financial institution to the other. DSR establishes the percentage of salary allocated for loan servicing, typically ranging from 40% to 50%. This ratio determines loan eligibility and safeguards against excessive debt burdens. This ratio is also a determinant of how much loan amount you can qualify for as stated earlier.

Early Settlement

While loans can be repaid before maturity, early settlement penalties may apply. However, the Central Bank frowns on this practice to ensure fair treatment for borrowers. How the loan amortization is structured for deductions makes it unfair for early settlement fees. Because, the repayment is structured such that less principal is deducted whilst chunk of interest is taken at the beginning. Therefore, if the loan does not travel at full length, the customer already does not benefit fully from lower effective rate. Early settlement is best when there is a windfall in cashflows and the loan is expensive or when rates are down and a new loan is needed at a lower cost to refinance the existing one. Understanding the implications of early settlement therefore helps optimize loan management strategies.

Option for a Top-Up

Consumers rarely enquire about top-up options when first contracting a personal loan. An option for a top-up varies from one institution to the other and where it exists, the conditions for it may differ from lender to lender. Consumers should inquire about top-up options because its availability facilitates future borrowing flexibility, especially during unforeseen financial needs.

Usually, you may have to pay up to a certain period from say six (6) months up to half the tenure of the current loan to qualify or you may have gotten substantial pay raise whichever comes first. Flexible top-up option is preferable as a risk measure.

Other conditions or terms

Since the salary is the underlying security for a personal loan, mostly, applicants must have accounts with the lending institution however with technology and innovation it is possible to stay with your bankers and borrow from another financial institution. Notwithstanding, some banks may still require you to switch your account. There could be covenants to also restrict you from borrowing further without recourse to your first lender because depending upon where your salary account sits, the first lender may be affected with additional borrowings. Depending on the sector you are coming from and its risk characteristics or your own past records, you may be asked to submit a guarantor.

It should not be lost on consumers that there are credit reference bureaus that keep records of personal borrowings from one institution to the other. All lending institutions would scrutinize every applicant for their credit records and therefore it is not possible to default with one lending institution and run to other for a facility. In conclusion, understanding personal loan terms and structures empowers consumers to make informed decisions aligned with their financial circumstances. By prioritizing understanding, individuals can navigate the borrowing process effectively, leading to satisfactory outcomes