Banks offering cheap loans, high returns are lying to you

India's major banks, including state-owned lenders, are pulling a major con job on small investors or borrowers – and the RBI is doing nothing about it, says Sanjay Matai

A few days back, I got a call from a bank offering me loan at a mere 8 per cent interest per annum. I naturally started to look for the hidden devil; and sure enough I found one.

What got me wondering was the fact that banks were taking deposits at 8-9 per cent. So if they lent me at 8 per cent, they would surely incur a loss! How would they cover their fixed costs like salaries, rent, electricity, etc? I wondered. Would a sensible bank run at a loss? Obviously not.

So let's understand the gimmick employed.

I was offered a loan of Rs2 lakh at a 'flat' rate of 8 per cent; repayable in two years, or 24 equated monthly instalments [EMIs]. Notice the word flat? This is the devil.

At this flat interest rate of 8 per cent,  the EMI payable works out as under:

  • Total interest = Loan amount * Interest Rate * No. of years =  2,00,000 * 8% * 2 =  32,000
  • Total repayment = Loan amount + Interest =  2,00,000 + 32,000 =  2,32,000
  • No. of instalments =  24 monthly payments
  •  Equated Monthly Instalment =  Total payment / No. of instalments =   2,32,000/24 =   9,666.67 per month

Simple? Yes. Cheap? Well, not exactly. So where's the catch?

By the way, this simple example does not include the loan processing charges; which will bump up the overall cost by another 1-2 per cent.

Avoid 'flat' interest rates

The catch is that you are paying EMI every month. A part of this amount is the interest portion and the balance the principal portion. So month after month, as you keep paying your EMIs, the principal outstanding is reducing, till it finally become zero at the end.

Technically one should pay interest only on the outstanding or the loan balance i.e. the remaining portion of your loan. But as I have shown, the interest has been calculated on flat basis or 'full loan amount' for the entire two years'.

In a 'flat interest rate' scenario we do not get the benefit of the reducing principal amount month after month. The result is that the effective interest cost to us, in the above offer, works out to as much as 14.68 per cent.

Now the bankers' policy makes sense. They borrow at 8-9 per cent and lend at 14-15 per cent.

I suggest that we as consumers should strictly avoid such supposedly cheap flat interest rate loans.

What interest rate do banks offer you for deposits

Let us look at one more example of such gimmicks.

Open any newspaper today and you are likely to be bombarded with many ads from banks for Fixed Deposit schemes, each pretending to offer better than its rivals.

This competition is definitely good for depositors. However, in their anxiety to sell their schemes, some banks are resorting to ads that border on the unethical.

The levels of financial literacy in India are low, and these ads are trying to exploit this weakness of the average investor. The most unfortunate part of this story is that these are among India's biggest banks, many of them state-owned.

Given below is one such advertisement, issued by a leading PSU bank regarding interest rates being offered on its fixed deposits.

The problem is that the annualised yields mentioned are WRONG. (see chart:)

TERM DEPOSIT RATES
Duration Interest Rate Annualised Yield *
1 year to 2 years
9.25%
10.03%
2 years to 3 years
9.25%
10.52%
3 years to 5 years
9.25%
11.59%
5 years to 8 years
9.25%
13.48%
8 years to 10 years
9.25%
14.95%
* Annualised yield at the end of the slab

These supposed yields are wrong because they make it appear that your annual return is, for example 14.75 per cent for a 10-year deposit; which is really not so.

Actually, the bank is calculating simple interest assuming as if your principal amount is constant throughout the 10-year period.

However, this is not the case. Every year you are earning interest. This interest gets added to your principal. So every year your principal is increasing. Hence, applying the simple interest formula to a compounding investment is tantamount to mis-selling.

If you keep your money for longer periods, naturally your total amount on maturity will be higher. If your maturity amount is more, naturally it will appear as if you have earned more money. This extra money will be seen as earning higher interest if you apply the simple interest formula. In short, the depositor is given a false impression of earning higher returns.

I repeat - this is wrong and misleading representation of the returns that you are actually getting.

In reality you are getting interest at 9.25 per cent, payable every quarter. And because of this quarterly compounding, the effective return or true annualized yield is 9.58 per cent, whatever may be the period of the fixed deposit.

Moreover, the interest rate is same for different periods. So logically how can the annualised yield be different?

I wonder why Reserve Bank of India presiding over this financial jugglery.