Loan alert: 8% means 15% in bankers’ jargon
Your sweet talking banker will assure you that an 8% interest rate on your car loan is the best you can get. After all, a home loan comes at that rate today. But there’s a big catch. Sanjay Matai reveals.
Today, availing of a loan – be it for a house, a car, a TV, a vacation, etc.- has become quite an easy & attractive proposition, both in terms of Cost & Convenience. Day-in and day-out we are being bombarded with advertisements which promise low-cost or even interest-free loans.
But, as usual, these advertisements and sales talk do not reveal the full story. The onus is on us to cut through the jargon and understand the real costs involved.
Flat interest rate, zero interest rate, advance EMIs, etc. are some of the commonly used terms, which need to be rightly interpreted,
as they can make significant difference to the actual interest one finally pays, month after month, year after year.
Flat Interest Rates
Flat interest rates, though appearing to be the cheapest on paper, are in fact the most expensive.
Under the flat rate methodology, the interest is calculated on the ‘full loan amount’ for the ‘entire loan period’. The fact that a part of the principal amount is being repaid with each EMI is not taken into consideration.
Say you borrowed Rs.1,00,000 at 8% ‘flat’ interest rate for 2 years. The total interest payable would be Rs.16,000. And the EMI would be (Rs.1,00,000 + Rs.16,000)/24 = Rs.4833.33 per month.
After 1 month the first EMI of Rs.4833.33 is paid, which comprises Rs.666.67 interest and Rs.4166.67 instalment. So after 1 month the loan outstanding is Rs.95,833.34. But as we have seen, the interest is calculated on full Rs.1,00,000. And so with each EMI payment the loan outstanding reduces but the interest is still calculated on Rs.1,00,000. Hence, we keep paying interest on the loan amount already paid-off.
The 8% flat rate is, therefore, in reality an interest cost of 14.68%.
Reducing balance method
Therefore, as we have seen above, it is important that interest should be calculated on the reduced balance.
But how the reducing balance method is applied – annually, quarterly, monthly or daily – will determine the effective cost. Assuming that the loan amount is reset annually for interest calculation while one is paying monthly instalments, the real interest cost would be more.
If in the 1st example, the annual reducing balance method is applied, the total interest payable would reduce to Rs.12,153.85, the EMI to Rs.4673.08. And the real interest cost would be 11.26%.
And when the monthly reducing balance is applied, the total interest payable would reduce to only Rs.8545.50, the EMI to Rs.4522.73. And the real interest rate would be 8%.
Zero interest rate
Very often we come across advertisements promising loans at ‘zero’ interest rate. This, however, may not really be true. By going in for the loan instead of 100% up-front payment, one may be forgoing the dealer discount. Also, there may be some advance EMIs payable, not to forget the loan processing and documentation expenses.
Say a car costing Rs.4 lakhs, is available for Rs.1 lakh down payment and a Rs.3 lakh zero-interest loan (payable in 12 equal instalments of Rs.25,000 each). Assume one pays a 2% loan processing and documentation fees on Rs.3 lakhs i.e. Rs.6,000 and foregoes a cash discount of say Rs.10,000.
Therefore, under the 100% up-front payment, the actual cash outflow would be Rs.3,90,000 (Rs.4,00,00 – Rs.10,000). Whereas,
under the loan option the outgo is Rs.4,06,000 (Rs.4,00,000 + Rs.6000). This additional cash outflow of Rs.16,000, indirectly means an interest cost of 5.33% and not zero percent.
If on top of this, say 2 advance EMIs are also payable. Then it means that the effective loan amount is only Rs.2.5 lakhs and the accordingly the indirect interest cost works out to 6.40%.
Advance EMI scheme
Some lenders promise 100% financing. But in such cases one may be asked to pay a few advance EMIs. This is a plain jugglery as (i) this is not 100% financing and (ii) the interest payable is calculated on the entire amount.
Assume a loan of Rs.1,00,000 is available @10% p.a. interest rate for 1 year with a monthly reducing balance. The effective cost would also be 10% since the benefit of monthly payment is being passed on and the EMI would be Rs.8792. If now, 1 EMI was
payable in advance, then the net loan amount one would receive would be Rs.91,208. The real interest cost under such a scenario would increase from 10% to 11.86%.
In addition to the interest, the banks also levy other charges. These could be the processing fees, administrative fees, pre-payment penalty, delayed payment charges etc. These costs should also be clearly understood and quantified, as they increase the effective cost of the loan. Say in the above example (with no advance EMI) a Rs.500 processing fee were also payable, the real cost would increase to 10.95%.
As the economists say, there is no free lunch. The lenders out there are not doing charity. If they give out free money, they will be soon out of business. So don’t get fooled by false promises. Do your homework. Remember, if you do not take care of your money,
you won’t be left with any - someone else would have taken it all away.
Today, availing of a loan – be it for a house, a car, a TV, a vacation, etc.- has become quite an easy & attractive proposition, both in terms of Cost & Convenience. Day-in and day-out we are being bombarded with advertisements which promise low-cost or even interest-free loans.
But, as usual, these advertisements and sales talk do not reveal the full story. The onus is on us to cut through the jargon and understand the real costs involved.
Flat interest rate, zero interest rate, advance EMIs, etc. are some of the commonly used terms, which need to be rightly interpreted,
as they can make significant difference to the actual interest one finally pays, month after month, year after year.
Flat Interest Rates
Flat interest rates, though appearing to be the cheapest on paper, are in fact the most expensive.
Under the flat rate methodology, the interest is calculated on the ‘full loan amount’ for the ‘entire loan period’. The fact that a part of the principal amount is being repaid with each EMI is not taken into consideration.
Say you borrowed Rs.1,00,000 at 8% ‘flat’ interest rate for 2 years. The total interest payable would be Rs.16,000. And the EMI would be (Rs.1,00,000 + Rs.16,000)/24 = Rs.4833.33 per month.
After 1 month the first EMI of Rs.4833.33 is paid, which comprises Rs.666.67 interest and Rs.4166.67 instalment. So after 1 month the loan outstanding is Rs.95,833.34. But as we have seen, the interest is calculated on full Rs.1,00,000. And so with each EMI payment the loan outstanding reduces but the interest is still calculated on Rs.1,00,000. Hence, we keep paying interest on the loan amount already paid-off.
The 8% flat rate is, therefore, in reality an interest cost of 14.68%.
Reducing balance method
Therefore, as we have seen above, it is important that interest should be calculated on the reduced balance.
But how the reducing balance method is applied – annually, quarterly, monthly or daily – will determine the effective cost. Assuming that the loan amount is reset annually for interest calculation while one is paying monthly instalments, the real interest cost would be more.
If in the 1st example, the annual reducing balance method is applied, the total interest payable would reduce to Rs.12,153.85, the EMI to Rs.4673.08. And the real interest cost would be 11.26%.
And when the monthly reducing balance is applied, the total interest payable would reduce to only Rs.8545.50, the EMI to Rs.4522.73. And the real interest rate would be 8%.
Zero interest rate
Very often we come across advertisements promising loans at ‘zero’ interest rate. This, however, may not really be true. By going in for the loan instead of 100% up-front payment, one may be forgoing the dealer discount. Also, there may be some advance EMIs payable, not to forget the loan processing and documentation expenses.
Say a car costing Rs.4 lakhs, is available for Rs.1 lakh down payment and a Rs.3 lakh zero-interest loan (payable in 12 equal instalments of Rs.25,000 each). Assume one pays a 2% loan processing and documentation fees on Rs.3 lakhs i.e. Rs.6,000 and foregoes a cash discount of say Rs.10,000.
Therefore, under the 100% up-front payment, the actual cash outflow would be Rs.3,90,000 (Rs.4,00,00 – Rs.10,000). Whereas,
under the loan option the outgo is Rs.4,06,000 (Rs.4,00,000 + Rs.6000). This additional cash outflow of Rs.16,000, indirectly means an interest cost of 5.33% and not zero percent.
If on top of this, say 2 advance EMIs are also payable. Then it means that the effective loan amount is only Rs.2.5 lakhs and the accordingly the indirect interest cost works out to 6.40%.
Advance EMI scheme
Some lenders promise 100% financing. But in such cases one may be asked to pay a few advance EMIs. This is a plain jugglery as (i) this is not 100% financing and (ii) the interest payable is calculated on the entire amount.
Assume a loan of Rs.1,00,000 is available @10% p.a. interest rate for 1 year with a monthly reducing balance. The effective cost would also be 10% since the benefit of monthly payment is being passed on and the EMI would be Rs.8792. If now, 1 EMI was
payable in advance, then the net loan amount one would receive would be Rs.91,208. The real interest cost under such a scenario would increase from 10% to 11.86%.
In addition to the interest, the banks also levy other charges. These could be the processing fees, administrative fees, pre-payment penalty, delayed payment charges etc. These costs should also be clearly understood and quantified, as they increase the effective cost of the loan. Say in the above example (with no advance EMI) a Rs.500 processing fee were also payable, the real cost would increase to 10.95%.
As the economists say, there is no free lunch. The lenders out there are not doing charity. If they give out free money, they will be soon out of business. So don’t get fooled by false promises. Do your homework. Remember, if you do not take care of your money,
you won’t be left with any - someone else would have taken it all away.
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