Types of loan interest in Uganda

If you're planning to take out a loan, whether personal or for business, you may be wondering how interest is calculated and how different types of interest can affect your overall repayment amount.

In this article, we will explain the various types of interest rates that exist in Uganda and how they are calculated. We will provide examples to help you understand how loans work and how to calculate them.

For instance, let's say you're taking out a loan of UGX 10,000,000 (ten million Ugandan shillings), and the loan duration is one year. How much will you have paid back by the end of the loan term, and what will be your monthly repayment amount if the repayment period is monthly? This article aims to answer the questions that you may have about loan interest rates and how they work, based on our own research and experiences.

But first...
what is Interest?

Interest is what you pay for using someone else's money. It is the cost or charge for the use of borrowed money.

Types of loan interest in Uganda

Generally speaking, there are two types of interest

1. Simple interest
2. Compound interest

Both Simple interest and compound interest have variations. And all loans and investments are mainly calculated from the two above, compound interest being the most used when it comes to loans and investment.

Other than the interest there are other factors that affect how much interest you pay back on a loan and it's important to understand these before we look at the different types of interest

1. Principal: The principal is how much money you are borrowing.
2. Loan term: This is how long you will take before completely paying off the loan. It's the time the money is borrowed for.
3. Repayment amount: This is how much you will pay back periodically to pay off the loan. The repayment period can be daily, weekly, bi-monthly, monthly, quarterly or annually depending on the loan
4. Interest rate: This is a percentage of the principal on which interest calculations are based

Now let's look at how interest works...

Simple Interest:

Simple interest is a straightforward method of calculating interest that is typically used for shorter-term loans or small amounts of money. It's based solely on the initial principal amount borrowed, without considering interest accumulating. Here's a breakdown of how simple interest works:

Formula for Simple Interest:
I = P × r × t

Where:

• ( I ) represents the interest accrued,
• ( P ) is the principal amount (the initial loan amount),
• ( r ) is the interest rate (expressed as a decimal),
• ( t ) is the time the money is borrowed for (usually in years).

Example of Simple Interest:

Let's say you borrow 1000,000 UGX from a money lender at a simple interest rate of 7% per annum, and you're required to repay the loan after 6 months. Here's how to calculate the interest:

Given:

• P = 1000,000 (Principal amount)
• r = 0.07 (7% expressed as a decimal)
• t = 6/12= 0.5 years (since 6 months is half a year)

Using the simple interest formula:
I = 1000,000 x 0.07 x 0.5
I = 35,000

So, the interest accrued over the 6-month period is 3,500 UGX.

Total Amount Payable:

To find the total amount you'll have to repay, you add the interest to the principal:
Total Amount = Principal + Interest
Total Amount= 1000,000 + 35,000
Total Amount = 1,035,000

So, at the end of the loan term, you'll have to repay a total of 1,035,000 UGX.

While the above is the formula for calculating simple interest, here are some variations that i have seen being used to calculate.

Variation 1: INTEREST ONLY
In this variation of interest calculation, instead of calculating the time as well, everything is calculated at once, for the 1 million loan above, the interest will be calculated as
I = P × r... without considering the time, which becomes
I = 1000,000 x 7% = 1000,000 x 0.007 = 70,000 and the total amount payable becomes
A = 1000,000 + 70,000 = 1,070,000

Variation 2: FLAT RATE
In this variation of interest calculation, interest is calculated per month, in that for the 1000,000 above, you pay 7% per month and the total payback depends on the number of months you take before you pay back the loan. Please note that the interest doesn't compound and the per month, can be per day, week, or 2 months, etc. So the 1 million loan above for each month you will pay 1000,000 x 7% = 70,000 and the total interest amount for the 6 months would be 6 x 70,000 = 420,000 and the repayment would be the principal plus the interest

A = 1000,000 + 420,000 = 1420,000 and therefore the total repayment amount would be 1420,0000

Compound Interest:

Compound interest is a more complex method of calculating interest, where interest is added to the principal sum, and future interest is calculated on the new total. This compounding effect leads to exponential growth in the amount owed over time, making compound interest particularly impactful over longer loan terms. Here's a detailed breakdown:

Formula for Compound Interest:
A = P X (1 + r)^n

Where:

• ( A ) represents the total amount after ( n ) periods,
• ( P ) is the principal amount (the initial loan amount),
• ( r ) is the interest rate per period (expressed as a decimal),
• ( n ) is the number of compounding periods.

Compound interest depends on the frequency at which interest is calculated. This frequency is known as the compounding period and it can be monthly, quarterly, or yearly, depending on the loan or investment. The interest rate per period is calculated by dividing the annual interest rate by the number of times that interest compounds per year. The more frequent the compounding period, the higher the interest rate per period and the more money that will be paid back. So, it's important to take into account the compounding period when deciding on a loan or investment.

Example of Compound Interest:

Let's use the same scenario as before: you borrow 100,000 UGX with an annual interest rate of 21%, and you're supposed to repay it over a period of 2 years.

Given:

• P = 100,000 (Principal amount)
• r = 21%/12 (Monthly interest rate)
• n = 2 x 12 = 24 (Total number of compounding periods)

Using the compound interest formula:
A = P X (1 + r)^n
A = 100,000 x (1 + 0.0175)^24

After solving, you'll find the total amount payable, which would be approximately 14,802,180 UGX.

When you take out a loan with compound interest, the bank or lender will provide you with a repayment plan. This plan will show you how to pay back the loan on a monthly basis, and also provide a breakdown of how each payment is distributed towards the interest and principal. This is commonly referred to as a loan amortization table. If you need to calculate how much you can afford to pay back on a loan, you can use a loan calculator to help you determine the amount.

Conclusion:

Understanding the differences between simple interest and compound interest is crucial for borrowers to make informed financial decisions. While simple interest is linear and straightforward, compound interest has a compounding effect that can significantly increase the amount owed over time. It's important to carefully consider these factors when taking out loans or making investments.

For further assistance with managing your finances and loans, consider exploring the Pesasave app, which offers valuable tools and resources to help you navigate the world of personal and business finance effectively.