The trick the media uses when it comes to showing how expensive sms loans are is to show what high effective interest rates these loans have and it is not at all such a stupid trick if you want to black paint the fast loan industry.
We have shown several times before how silly it is to talk about effective interest rates when it comes to really short loans because they only show how much in interest you get to pay if the loan has a maturity of at least one year.
Using effective interest rates when comparing loans that have at least 1-year maturity with a loan that has a 1-month maturity is thus misleading as it is based on annual interest expense, on the other hand, it can be a good “measure” when comparing short fast loans with each other.
Borrowing cost in relation to the loan amount
However, there is another measure you can use if you want to see what the credit actually costs. It is to look at how much of the total repaid amount consists of interest costs and fees, ie how much the loan cost is in relation to the loan’s original size.
Example: If you borrow USD 10000 and repay a total of 11000, the loan has a cost of USD 1000, ie 10% of what you borrowed. This measure shows more what the loan actually costs.
How expensive is an sms loan
Compared to a private loan if we use this measure? Good Finance will give you some examples that illustrate this and we start by looking at some typical short loans that have a fairly high (and very high) effective interest rate.
- Example 1. If you borrow USD 5000 for 61 days with E-Money you get an effective interest rate of 222%. Of course, it sounds horribly a lot when compared to loan loans that can have an interest rate of 3.75% or similar. However, the loan cost for this loan is USD 770, which is 15.4% of the loan size.
- Example 2. You take an online credit at Good Credit Bank of USD 10000 which you repay for 3 months. The loan has an effective interest rate of 200%. You then get a total loan cost of USD 945, which is 9.45% of the size of the loan amount.
- Example 3: Now let’s take into account the effective interest rate (which gets extra high for really small loans): You only borrow USD 1000 from Monetti (which has reasonable costs for slightly larger fast loans, but is expensive when it comes to their very smallest loan due to the setup fee) for one month, then you get an effective interest rate of 5641%! In any case, the loan costs USD 450 (which is unusually expensive even for sms loans, there are many that do not cost half as much and some of these are free) and this means that the interest rate of the loan is 45%.
Okay, then we have got some control over what interest rates can be when we use this measure, so it was about 9.45%, 15.4%, and a whole 45%. Now let’s look at what it looks like on the private loan front.
We use a fairly low-interest rate so as not to distort the reality
We choose to look at what loans that have an effective interest rate of 5.79% cost. If you want to check that our amounts are correct, you can always check them on Advisa’s website because it was from there that we collected the figures this time, and they matched up just as well with our own calculation.
- Example 1: We start by looking at a really large net loan of USD 500,000 with a 15-year maturity. Despite the relatively low effective interest rate of 5.79%, the loan cost is as much as USD 243,140, almost half the size of the loan (48.4%). Of course, this is due to the long term, but seriously speaking, the loan cost in relation to the size of the loan is still extremely high in percentage terms. Yes, the interest rate is actually higher than Monetti’s small USD 1,000 loan with an effective “usury rate” 5,641%.
- Example 2: Suppose you buy a new car for USD 200,000 and take out an unsecured loan to pay for it and repay it for 6 years (which is quite common), then you get a loan cost of USD 36,232. This is 18.1% of the amount you borrowed and is more than what E-Money’s USD 5000 loan in the example above cost in relation to the size of the loan.
- Example 3: You take out a loan of USD 50000 to pay for a small renovation at home and payback on it for 2 years. Then you get a total cost of USD 2,992, which is 6% of the borrowed amount.
It is only in the last example that private loans start to become cheaper than sms loans in relation to the size of the loan amount. Of course, this is due to the rather short term. The bottom line is that sms loans are not really as expensive as the critics try to make them appear and that it is only when the loans have a maximum maturity of 2, 3 years that private loans are cheaper in relative terms.