How a Loan at 4% Costs You 11%?

You purchase your favourite gadget/furniture. At the sales counter, you notice an offer of taking a loan for the purchase amount at 4%. You get excited. After all, you get a higher rate of interest in a fixed deposit. It makes for a nice arbitrage opportunity. Let’s understand such offers with the help of an example. You purchase an item worth Rs 1 lac. You take loan for the purchase amount and you need to repay Rs 1.04 lacs (At an advertised rate of 4%) over the next 12 months. You need to pay 12 EMIs of Rs 8,667 each (Rs 1.04 lacs/12). Fair enough. In absolute terms, it appears that the cost of loan is 4% p.a. However, we also need to look at the timing of cash flows and the other costs involved. Is the cost of the loan really 4%? No, it is not. The cost of the loan is much higher. How? Let’s find out.

First EMI is adjusted with the amount itself. The lender adjusts the first EMI with the loan amount itself. In a way, you pay the first EMI at the time of availing loan itself. You are taking a loan of Rs 91,333 (Rs 1 lac – Rs 8,667) and returning Rs. 95,333 (Rs 1.04 – Rs 8,667). This takes the cost of loan to 4.38%.

Don’t ignore the processing fee (and the service tax). If the processing fee is 1% of the purchase amount, you have to incur those charges too. Typically, processing fee is adjusted with the loan amount. Hence, your effective loan amount will go down further. And don’t forget about the service tax. At 1%, loan processing fee is Rs 1,000. Add service tax of Rs 150 (at 15%). Essentially, while taking the loan, you will pay Rs 9,817 upfront (Rs 1 lac – Rs 8,667 – Rs 1,000 – Rs 150) and you take the loan for the remaining amount (Rs 90,183). For a loan of Rs 90,183, you have to repay Rs 95,333. Now, the cost is 5.71%.

Pay attention to the timing of loan repayment. If you were to repay the entire loan at the end of the year, the cost of the loan would have actually been around 5.7% p.a. However, that’s not the case. It is a reducing balance EMI schedule. A portion of every EMI goes towards interest payment while the remaining goes towards principal repayment. Since the first EMI was adjusted with the loan amount, you have only 11 months to repay the loan. With the loan amount of Rs 90,183 and 11 EMIs of 8,667, the cost of the loan is actually 11.25% p.a. If you are not convinced, here is the proof. At interest rate of 11.25% p.a., the outstanding principal becomes Nil at the end of 11 months.

Interest Rate11.25%
MonthO/S at the Beginning of the monthEMIInterest PaidPrincipal RepaidO/S at the end of the month

You can see the cost is not 4% p.a. or 5.7% p.a. but 11.25% per annum. This happened because you didn’t just pay interest at the end of the year, but in all the EMIs.  Another way to look at it — you did not get to use the full Rs 1 lac amount for 12 months. Your outstanding principal kept reducing with each payment.

Points to Note

You will get such offers only from NBFCs (non-banking finance companies). As I understand, banks are prohibited by the Reserve Bank to indulge in such tricks. The cost to you is the return to the lender with minor adjustments. Service tax on processing fee does not go to the lender. That will bring down the return. However if the lender has negotiated a discount (on the product) with the dealer, the return to the lender will be much higher than 11.25% p.a. For instance, even though the products cost Rs 1 lac to you, the lender makes a payment of only Rs 97,500 to the dealer. The return to the lender is 16.69% p.a.

What Should You Do about Such Schemes?

You need to dig deeper before you opt for such schemes. The effective cost of such loans is much higher than the advertised rate. I have considered an advertised cost of 4%. You can break down any such offer in a spreadsheet and calculate the effective cost. In my opinion, if you have the funds to make the purchase outright, make the outright payment. Why do you want to incur cost of 11.25% p.a.? What if you don’t have the requisite funds and still need to make the purchase? In that case, at 11.25% p.a., the cost of the loan may be lower than the interest rate for personal loan. Hence, if you cannot afford the entire purchase cost, it may be an option worth considering. Do note 11.25% p.a. is the cost of loan for advertised cost of 4% and processing fee of 1%. If you change the inputs, the effective cost of loan will change. By the way, such offers can be structured in many different ways. However, you can easily break down the cost components in a spreadsheet and calculate the effective cost for decision making.

Additional Read

  1. Capital Mind: How a 4% loan for furniture costs you 12%?
  2. The Curious Case of 0% EMI schemes
  3. Why did RBI ban 0% EMI schemes?