A friend was planning to take a home loan of Rs 75 lacs. With an EMI of Rs 66,278 for 20 years. Over the 20 years, the total of all payments will be Rs 1.59 crores. So far, so good. Now an interesting twist.
He calculated the cost of this home loan as 3.83% p.a. Now, 3.83% p.a. sounded too low for a home loan product. And at this low cost, the home loan looked like a steal deal to him. An almost no-brainer.
Why would you put your own money to purchase a house when a home loan was available at 3.83% p.a.? Even today, you can create a bank FD at ~7% p.a. However, you do not get home loans at 3.83% p.a., at least in India. Where did he go wrong?
How Did He Calculate 3.83%?
Loan amount is Rs 75 lacs. EMI of Rs 66,278 for 20 years. Total payment of Rs 1.59 crores over 20 years to close the loan.
The error: Rs 75 lacs grows to Rs 1.59 crores in 20 years at a CAGR of 3.83% p.a.
The incorrect assumption: To calculate the cost of loan, he considered one-shot repayment of Rs 1.59 crores at the end of 20 years.
The correct way is to calculate IRR with an initial inflow of 75 lacs followed by outflow of Rs 66,278 for 240 months. The IRR would be 8.75% p.a. And that is the actual cost of the home loan (I have not considered any tax benefits).
Paying Rs 66,278 every month for 20 years is far more expensive than paying (Rs 66,278 X 12 X 20 = Rs 1.59 crores) at the end of 20th year. Simple time value of money concept.
In this case, he had mentioned that the loan interest rate is 8.75% p.a. Still, he made this error. I hope the actual cost would have dawned upon him eventually. Plus, the end use was clear. He was planning to buy a house.
This could have been a problem if he were evaluating an investment opportunity.
By the way, there is nothing wrong in buying a house with a home loan. However, it is not fine if you underestimate the cost of a product. Because that could lead to unwise financial decisions.
Let us take a Rs 5 lac loan at 24% p.a. for 5 years. That is 2% per month. That is an expensive loan.
EMI of Rs 14,383.
Total payment of Rs 8.63 lacs over 5 years.
If you calculate in the proper way as I suggested above (initial inflow of Rs 5 lacs followed by an outflow of Rs 14,383 per month for the next 5 years), you will arrive at the right cost of loan i.e., 24% p.a.
However, if you botch things up (inflow of Rs 5 lacs followed by one shot outflow of Rs 8.63 lacs after 5 years), you will calculate the cost of loan as 11.54% p.a. 11.54% p.a. is expensive but not as expensive as 24% p.a.
Why Does Your Calculation Matter?
Even if you calculate the cost incorrectly, how does that matter? The real cost of the loan remains unchanged at 24% p.a. That’s right. The cost of loan does not change but the calculation does matter.
What if you are evaluating taking a loan to make an investment where you expect to earn 20% p.a.?
If you incorrectly think the cost of the loan is 11.54% p.a., you will take the loan for the investment. And if you did that, you would end up losing even if your investment were to deliver an expected 20% p.a. Had you known that the cost of loan is 24%, the entire strategy would have been a non-starter.
And this is just the interest cost. I have not even considered other ancillary costs that are not always obvious. A good example is the loan processing fee.
Therefore, it is important you know how loans work and how to calculate the cost of loans. Getting this right would help avoid mistakes in evaluating investment opportunities.