On the account of Covid-19 related lockdown and associated financial stress, RBI had offered loan moratorium to borrowers. We checked in some of our earlier posts how availing loan moratorium provided immediate relief but increased your liability (same EMI but longer tenure OR same tenure but higher EMI).
A component of increase in liability was due to compounding of interest.
Related Reading: EMI Moratorium Math Explained
How Does Compounding of Interest Work during Loan Moratorium?
You start with a loan of Rs 1 lacs at the interest rate of 12% per annum or 1% per annum.
In the first month, the interest component will be Rs 1 lac X 1% = Rs 1,000.
If you had availed moratorium, this unpaid interest got accrued and added to your outstanding principal amount.
Thus, after the first month, your outstanding will be Rs 1.01 lacs.
In the second month, the interest will be charged on the original principal (Rs 1 lac) and the accrued interest (Rs 1000).
Hence, the interest for the second month will be (Rs 1 lac + Rs 1,000) * 1% = Rs 1,010.
In this way, you are being charged interest on interest. Here is an illustration.
| Loan Amount | 1,00,000 | 5,00,000 | 30,00,000 | 50,00,000 |
| Interest Rate | 12% | 9.0% | 9.0% | 9.0% |
| Remaining Tenor (months) | 12 | 60 | 180 | 240 |
| EMI | ₹8,885 | ₹10,379 | ₹30,428 | ₹44,986 |
| Monthly interest rate | 1.00% | 0.75% | 0.75% | 0.75% |
| Interest for the 1st month | 1,000 | 3,750 | 22,500 | 37,500 |
| Principal O/s at the end of 1st month | 1,01,000 | 5,03,750 | 30,22,500 | 50,37,500 |
| Interest for the 2nd month | 1,010 | 3,778 | 22,669 | 37,781 |
| Principal O/s at the end of 2nd month | 1,02,010 | 5,07,528 | 30,45,169 | 50,75,281 |
| Interest for the 3rd month | 1,020 | 3,806 | 22,839 | 38,065 |
| Principal O/s at the end of 3rd month | 1,03,030 | 5,11,335 | 30,68,008 | 51,13,346 |
| Interest for the 4th month | 1,030 | 3,835 | 23,010 | 38,350 |
| Principal O/s at the end of 4th month | 1,04,060 | 5,15,170 | 30,91,018 | 51,51,696 |
| Interest for the 5th month | 1,041 | 3,864 | 23,183 | 38,638 |
| Principal O/s at the end of 5th month | 1,05,101 | 5,19,033 | 31,14,200 | 51,90,334 |
| Interest for the 6th month | 1,051 | 3,893 | 23,357 | 38,928 |
| Principal O/s at the end of 6th month | 1,06,152 | 5,22,926 | 31,37,557 | 52,29,261 |
| Tenure kept constant but EMI changed | ||||
| EMI for the increased principal (New EMI) | 9,431 | 10,855 | 31,823 | 47,049 |
| Increase in EMI | 547 | 476 | 1,395 | 2,063 |
| Total excess payment over the loan tenure | 6,559 | 28,555 | 2,51,135 | 4,95,053 |
| EMI kept constant but Tenure changed | ||||
| No. of EMIs required to repay the loan | 12.8 | 63.5 | 198.7 | 274.9 |
| No. of Extra EMIs to be paid | 0.79 | 3.52 | 18.66 | 34.92 |
| Total Excess Payment over the loan tenure | 6,994 | 36,505 | 5,67,723 | 15,71,087 |
Nothing wrong with this. This is called compounding of interest. And that’s how loan calculations work. In fact, that’s how your bank fixed deposits work. You interest income gets compounded. Hence, not many questioned this compounding of interest (interest on interest) during loan moratorium.
Further Reading: With Loans, the Power of Compounding Works in Reverse
One gentleman differed. Gajendra Sharma, a resident of Agra, petitioned to the Supreme Court of India that interest should not be charged on loans during the moratorium period. If that’s not possible, at least the interest on interest should not be charged. After all, the Government locked the economy down. There is little the borrowers could do. And if the banks charge interest on interest (compound interest), it is no relief. You are providing the relief now but the repayment burden will increase sharply once the moratorium is over.
I will not go into the legal and financial merits of the case but the “interest on interest” argument found favour with the Supreme Court and the Government was asked to look into this. There is news of “interest on interest during the loan moratorium period” to be waived. Or rather the Government will bear of the burden of such compound interest for loans under Rs 2 crores. I will write about this when the final guidelines are issued.
However, it is still interesting to understand the potential impact.
In the example considered above, the interest was Rs 1,000 for the first month, Rs 1,010 for the second month, Rs 1,020 for the third month and so on. If the compound interest (interest on interest) was waived (or Government took the burden), the interest for each of the 6 months will be Rs 1,000.
| Loan Amount | 1,00,000 | 5,00,000 | 30,00,000 | 50,00,000 |
| Interest Rate | 12% | 9.0% | 9.0% | 9.0% |
| Remaining Tenor (months) | 12 | 60 | 180 | 240 |
| EMI | ₹8,885 | ₹10,379 | ₹30,428 | ₹44,986 |
| Monthly interest rate | 1.00% | 0.75% | 0.75% | 0.75% |
| Interest for 6 months (Compound Interest) | 6,152 | 22,926 | 1,37,557 | 2,29,261 |
| Principal O/s at the end of 6th month | 1,06,152 | 5,22,926 | 31,37,557 | 52,29,261 |
| Interest for 6 months (Interest on Interest waiver) | 6,000 | 22,500 | 1,35,000 | 2,25,000 |
| Principal O/s at the end of 6th month | 1,06,000 | 5,22,500 | 31,35,000 | 52,25,000 |
| Interest on Interest | 152 | 426 | 2,557 | 4,261 |
| With Compound Interest | ||||
| EMI for the increased principal (New EMI) | 9,431 | 10,855 | 31,823 | 47,049 |
| Increase in EMI | 547 | 476 | 1,395 | 2,063 |
| Total excess payment over the loan tenure | 6,559 | 28,555 | 2,51,135 | 4,95,053 |
| With Interest on Interest Waiver | ||||
| EMI for the increased principal (New EMI) | 9,418 | 10,846 | 31,797 | 47,011 |
| Increase in EMI | 533 | 467 | 1,369 | 2,024 |
| Total excess payment over the loan tenure | 6,397 | 28,024 | 2,46,467 | 4,85,852 |
| Difference Between Compound Interest and Interest on Interest Waiver | ||||
| Difference in EMI | 13.51 | 8.85 | 25.93 | 38.34 |
| Difference over the loan tenure | 162 | 531 | 4,668 | 9,201 |
As you can see, there is not much difference. While you save some money over the loan tenure, the savings are not stark. For instance, for Rs 50 lacs (20-year loan at 9%), EMI went up from Rs 44,986 to Rs 47,049 after accounting for compound interest. If compound interest was waived during the moratorium period, the new EMI would be Rs 47,011. A difference of only Rs 38 per month. Over 20-year loan tenure, that’s a difference of just Rs 9,201.
In my opinion, not much difference between compound interest and interest on interest waiver. Note that the difference could have been bigger if the moratorium was for a longer period.