labels: investment - general
Interest rate jugglerynews
13 January 2006

Taking that tempting on-demand low-interest loan or some seductive 'zero-interest' 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 over-enthusiasm 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 'zero-interest' 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 zero-interest 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.

Pre-payment penalty
If there was no part-payment or pre-payment 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 pre-pay amounts as and when you can, and save on interest.

Alternatively, if the interest rates were to fall, you could pre-pay the entire loan and take a new one at a lower interest rate. But, if there was a part-payment or pre-payment penalty, then you would have to do a cost-benefit analysis each time you were to pre-pay.

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 hard-earned 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.

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Interest rate jugglery