You can get loans instantly these days. These instant personal loans are typically of small amounts and for shorter tenure. Every loan has an associated cost. For the long tenure loans, the interest rate is the primary determinant. You prefer to go with the lender that offers you the lowest interest rate. However, the same does not apply for short duration loans. If you focus only on the interest rates for the short-term loans, you may end up selecting a high cost loan.
In this post, let’s look at the aspects that must keep in mind while taking an instant loan. I write this post purely from the cost perspective. With instant loans, there are a few behavioural aspects to be addressed too. For instance, you may end up spending more if the credit is instantly available. Reckless spending can push you towards the debt spiral. However, in this post, let’s stick to the cost aspect. I work with the assumption that the instant loans will be of small amounts and for a short tenure. For short term loans, a good measure of cost can be the excess amount (over the loan amount) that you pay to close the loan. For if you pay Rs 53,000 towards repayment of Rs 50,000 loan, you have paid 6% of the loan amount in interest and charges. APR (Annual Percentage Rate) is also a good indicator.
The Quantum of the Processing Fee Becomes Important
For that matter, any one-time fixed charge becomes important too. The reason is this fixed charge is spread over the short tenure of the loan. Even if we do some crude calculation, a 2% processing fee for a loan for 6-month loan adds 0.33% per month (2%/6 months) in terms of interest rate.
In some cases, there may be a flat charge for the service. For a short quantum and short tenure loan, this can be a significant cost. For instance, if there is a miscellaneous charge of Rs 300 on a Rs 20,000 loan, the charge is 1.5% of the loan amount.
The Rate of Interest Is a Lesser Problem for Short Tenure Loans
For short term loans, the rate of interest is a lesser worry. Since the loan tenure is less, the reverse compounding does not get into overdrive.
For instance, if you take a loan of Rs 50,000 for 6 months at 10% p.a., you pay an EMI of Rs 8,578. Had the rate of interest been 15% p.a. (a full 5% higher), the EMI would have been Rs 8,701. A difference of Rs 123. Total difference of Rs 678. Or 1.36% of the loan amount.
Now, if the 10% loan had a processing fee of 2.5% and 15% p.a. loan had no processing fee, you would pay a processing fee of Rs 1,475 (including GST) in the 10% loan and NIL in 15% loan.
In the 10% loan, you pay Rs 1,475 extra fee. In the 15% loan, you pay Rs 678 extra interest.
If we compare on the APR, the effective APR for the 10% loan is 20.75% p.a. (assuming processing fee is set off against the loan amount).
|Loan Amount||Rs 50,000|
|Loan Tenure||6 months|
|Interest Rate||EMI||Processing Fees (%)||Processing Fees (₹)||Total Payment |
|10%||Rs 8,578||2.50%||Rs 1,475||Rs 52,943||20.75%|
|15%||Rs 8,701||–||–||Rs 52,206||15.00%|
It is an instinct to compare loans on interest rates. However, as you can see from the above example, for the short-term loans, the fixed charges such as processing fee can play a big role in your decision.
As the tenure gets longer, the interest rate becomes more important. Want an example? Look no further than interest rates. The difference between EMI for 10% and 15% home loans (50 lacs, 20 years) is Rs 17,588. This amounts to an extra Rs 42.2 lacs to be paid over the loan term. Almost 85% of the loan amount.
The Old Interest Rate Tricks
Though this may not always happen, the lenders can sometimes give a false impression about the interest rates. I have seen these tricks in play in case of Corporate Fixed Deposits. You can read about such a loan offering here. For instance, you take a loan of Rs 1 lacs and you must pay back 1.05 lacs over the 6 months. 6 EMIs of Rs 17,500. You might be given the impression that the interest rate is 5% since you just have to pay Rs 5,000 extra (5% of Rs 1 lac). If you work the APR for this loan, it would come out to 16.9% p.a.
As a borrower, you must do these basic calculations when you finalize your loan product. For all you know, a higher interest rate option may be the cheaper one. With our loan calculator or excel as your friend, you would have figured out that the higher interest rate offer is the cheaper one.