Taking
that tempting ondemand lowinterest loan or some seductive
'zerointerest' vehicle finance can cost you more than
you think, says Sanjay Matai. A primer to understand interest
rates and calculate the true cost of your loan.
Till
a few years back, it was virtually impossible for individuals
to avail of loans, whether for a car, a house or any other
personal use. That is now history. Today, you can get
a loan sitting in the comfort of your house. They are
just a phone call away. And the best part is that the
interest rates have dropped sharply, making them quite
affordable.
But
hold the celebration, there's need for caution here. In
their overenthusiasm to garner more and more business,
banks and various other lenders are putting out advertisements
that do not always give a complete picture about the overall
cost of their loans.
The
way the interest rate is defined and applied makes a lot
of difference to the total amount of interest that borrowers
end up paying. It is important that we clearly understand
the meaning of the words in 'small print' like flat rate,
daily or annually reducing balance, etc, and also take
into account 'other charges'. This is the only way to
calculate the overall cost of the loan and then do a meaningful
comparison with similar products from other lenders.
Flat
rate
One of the most common interest systems is the flat rate.
At first glance, this appears to be much cheaper. But
if we understand the concept fully we realise that in
many circumstances, one effectively ends up paying much
higher interest. Under the flat rate system, interest
is charged 'for the entire loan tenure'. It does
not take into account the fact that the principal amount
keeps on reducing as you make EMI payments.
Suppose
you were to borrow Rs1 lakh at 8 per cent flat rate for
two years. The total interest works out to Rs16,000. The
equated monthly installment (EMI) would then work out
to Rs4,833.33 per month (Rs100,000 principal + Rs16,000
interest divided by 24 months).
After
one month, you will have paid back Rs4,166.67 of the principal
and Rs666.67 in interest. Therefore, the loan principal
outstanding after one month is Rs95,833.33. But your interest
has been calculated at the full loan amount of Rs100,000,
irrespective what you have repaid. This means that from
the second month onwards, you will be paying interest
even on that part of the loan amount which you have already
repaid. It gets worse as the months go by. In the third
month, your loan outstanding reduces to Rs91,667.67, but
your interest is still calculated on Rs100,000. And, this
continues till the entire loan is paid off.
This
actaully means that your true interest cost actually works
out to a whopping 14.68 per cent, as against the 8 per
cent you think you are paying. Don't be misled by a 'low'
flat rate. Find out the effective cost. There may be other
options that are actually cheaper, though they may, on
the face of it, seem expensive.
Reducing
balance
In the flat rate, you do not get the benefit of reducing
balance. Therefore, it may be better to take the loan
that takes into account the progressive reduction in the
loan amounts. This benefits you as you pay interest only
on the loan amount actually outstanding. You must check
withg the lender whether the reducing balance is calculated
on the daily, monthly, quarterly or annual loan outstanding.
The catch here is that depending on the method applied,
your effective cost could be higher than the stated one.
Suppose
you are paying monthly EMIs, under the reducing balance
method and the lender calculates the reducing on the annual
or quarterly reducing balance method. In this case your
effective cost would be higher, because the interest is
calculated on the loan amount outstanding at the beginning
of the year or quarter. Even when you make payments monthly
during the year or quarter concerned, the loan amount
would be readjusted by the lender only after the end of
the year or end of that quarter, without giving you the
benefit of the amount you have repaid. This means your
effective cost would be higher.
Assume
that the lender allows you the benefit of only an annual
reducing balance; your EMI reduces to Rs4,673.08 and the
effective cost works out to 11.26 per cent. The total
interest payable works out to Rs12,153 versus Rs16,000
earlier.
Now
suppose the lender gives you the option of a monthly reducing
balance (which matches with your monthly payments). In
this case, your EMI would work out to Rs4,522.73 and the
effective cost would be the same as the stated 8 per cent.
The total interest payable would work out to only Rs8,545.50,
against Rs12,153 under the annual reducing balance method
and Rs16,000 under the flat rate method.
Lets
us suppose the system was changed to a daily reducing
balance. It would be the same as the monthly reducing
system, since you make your payments monthly. But this
method could come in useful in case you make payments
in between your normal monthly payments. Otherwise, you
will get the benefit only after the next reset is due.
The
'zerointerest' scheme
It sounds too good to be true. Why should anyone give
you free money to use? There must be some catch here.
One possibility might be that the dealer is not passing
on some discount, which you would have otherwise got if
you were making a full payment upfront. Indirectly, this
becomes the cost of taking the finance from the dealer.
Further, the dealer may charge you some 'documentation
fees', say 2 per cent of the loan amount. He might also
ask you to pay some advance EMIs upfront.
Assume
that a dealer sells a car worth Rs4 lakh for a down payment
of Rs1lakh and the balance Rs3 lakh is financed from a
zerointerest loan payable in 12 equal installments of
Rs25,000 each. On the Rs3 lakh, you pay documentation
fees of, say, 2 per cent or Rs6,000. Further, you don't
receive the cash discount of, say, Rs10,000, being offered
by the company.
If
you were to payn the entire amount upfront, your outgo
would work out to Rs390,000 (Rs400,000 less Rs10,000 discount
from the company). With the financing option, however,
the outgo becomes Rs406,000 (Rs400,000 plus Rs6,000 documentaaaation
fees at 2 per cent of the loan amount of Rs300,000). By
taking a loan, your total outgo has increased by Rs16,000
— an interest cost of 5.33 per cent, not zero per
cent, as advertised.
Further,
the dealer may ask you to pay, say, two EMIs upfront.
This means he is effectively financing you for Rs2.5 lakh
only. An additional cost of Rs16,000 on Rs2.5 lakh works
out to an interest cost of 6.40 per cent.
Advance
EMI scheme
Under the advance EMI scheme, the dealer could finance
you even up to 100 per cent, but ask you to pay a certain
number of EMIs in advance. In effect, however, you are
not getting 100 per cent finance. Second, your effective
cost after paying the advance EMIs works out higher than
the stated rate. This is because you are actually getting
finance of less than 100 per cent, but your interest is
calculated on the entire amount.
If
you borrowed Rs100,000 @10 per cent per annum with a monthly
reducing balance for a period of one year, the EMI works
out to Rs8,792. Since the loan reduces monthly, the effective
rate is 10 per cent. But if you were to pay one EMI upfront,
the net finance available to you would decrease by that
amount to Rs91,208 and you would have to repay the remaining
11 EMIs of Rs8,792 each. This works out to an effective
cost of 11.86 per cent, not 10 per cent.
Instead
of advance EMIs, it would be a better option to pay the
amount as a down payment and treat only the balance as
a loan. This way, your cash outflow remains the same,
but you end up paying interest on a smaller loan amount.
Other
charges
 Processing
& Administrative fees
While
taking a loan, you also end up paying other charges such
as processing fees, administrative fees, etc. These costs
should also be added to the effective rate calculations,
to arrive at the overall cost of the loan. Though small,
these charges are payable up front, and can significantly
increase the overall costs.
Suppose
you borrowed Rs100,000 @10 per cent per annum with a monthly
reducing balance for a period of one year. The EMI works
out to Rs8,792. Since the loan amount reduces monthly
according to your payments, the effective rate is also
10 per cent. But, if you were asked to pay Rs500 as processing
fees, your effective cost would jump from 10 per cent
to 10.95 per cent.
Prepayment
penalty
If there was no partpayment or prepayment penalty, you
should be able to pay off your loan (or a part of it)
before the due date, should your financial situation improve.
This is more relevant for housing loans, which are usually
of a long tenures of 10 to 20 years. During this period,
you could prepay amounts as and when you can, and save
on interest.
Alternatively,
if the interest rates were to fall, you could prepay
the entire loan and take a new one at a lower interest
rate. But, if there was a partpayment or prepayment
penalty, then you would have to do a costbenefit analysis
each time you were to prepay.
Delayed
payment charges
During the tenure of the loan, you might get into financial
difficulties and be forced to delay the payment of some
of your EMIs. In such a situation, the bank will charge
you penal interest. Therefore, look for banks that have
the lowest penal interest charges.
There
is no such thing as a free or cheap loan. It is very important
for the borrower to read the loan documents very carefully,
become aware of all costs and then do calculations to
work out the effective costs of the loan. This may seem
cumbersome and difficult, but the effort is worthwhile,
as it can save a lot of your hardearned money. Alternatively,
assuming that all other costs and
conditions are the same, one could compare the EMI per
lakh (not the interest rate) of various options for the
same tenure, and choose the cheapest one.
