Many Indian banks offers loans to NRIs (Non-resident Indians). However, since the rate of interest for loans is higher in India as compared to personal loans abroad, it is tempting to take a personal loan abroad instead of taking a loan in India. In fact, I know borrowers who have taken a personal loan abroad to purchase a house in India. While it seems like a good idea, here are a few things that you need to keep in mind.
#1 Check if the Loan Abroad Is a Flat Interest
There are two broad ways in which interest is charged on your loan.
- Flat interest rate
- Reducing balance (or diminishing interest rate)
Under flat interest rate, the total interest outgo is calculated upfront on the entire loan amount. The principal amount and the interest are added. The resulting amount is divided by the loan tenure in months to arrive at EMI amount.
Let’s say you take a loan of Rs 5 lacs at 4% p.a. (flat interest rate) for a tenure of 5 years.
Total Interest = Rs 5 lacs * 4% * 5 years = Rs 1 lacs
Total Repayment = Rs 5 lacs + Rs 1 lacs = Rs 6 lacs
EMI for 5 years = Rs 6 lacs / 60 months = Rs 10,000 per month
Under a reducing balance loan, interest is charged every month only on the outstanding principal. Every month, a portion of your EMI goes towards interest and remaining towards principal repayment. Since the principal outstanding goes down every month, interest portion of the EMI goes down while the principal repayment goes up every month. For more on how reducing balance loans work, go through this post.
If you take a loan of Rs 5 lacs at 4% p.
a. (under reducing balance method) for 5 years, your EMI for 60 months will be Rs 9,208 under reducing balance and Rs 10,000 per month under flat interest rate.
Something doesn’t look right, does it? Well, that’s how flat interest rate loans work. In flat interest rate loans, the interest is calculated on the initial (entire) loan amount. Under reducing balance loans, the interest is charged only on the outstanding amount. Using IRR function in excel, you can figure out the effective cost of loan for a flat interest rate loan. This cost can then be compared to reducing balance interest rate for the loan in India. The flat interest rate at 4% (for the loan described above) is equivalent to 7.42% under reducing balance loan. I have discussed the difference betw
een the two methods with examples in an earlier post.
I checked out a loan comparison portal in UAE. You can clearly see the different interest rates for flat rate and reducing balance loans.
Clearly, if the loan offered is a flat interest rate loan, the effective interest rate is not as low as you may think. You may ignore this minor variation when you are signing up for the loan. If you can borrow at 3.85% p.a. abroad and use the funds for which you would have had to take a loan at 9% p.a.), the deal looks attractive. However, 3.85% is flat interest rate and 9% p.a. is reducing balance. Apples and Oranges. If the comparable interest rate is 6.99% (reducing balance), you will think twice.
#2 Do Not Ignore Potential Currency Fluctuations
This is more of a concern if you are taking a loan abroad to invest in India. If you plan to use the cashflows from such an investment to repay the loan abroad, rupee depreciation can cause big trouble. This investment could be an NRE fixed deposit (to exploit interest rate differential) or even a stock market investment in India. Taking a loan abroad to invest in NRE FDs is not interest rate arbitrage and has some risks (but can be managed by buying currency forwards). However, taking a loan abroad to invest in equity markets in India should be avoided. Rupee depreciation can also be problem if you eventually want to take money back to the foreign country. However, not everything is so gloomy.
Many NRI borrowers take a loan at a lower cost abroad and send that money to India for investments or asset purchases (replacement for a rupee loan). However, instead of relying of the cashflows from the investment made in India, they use their local income (in foreign currency) to repay the loan. This is a better approach in my opinion. Firstly, since you know that you have to repay your local cashflows, there may be a lower tendency to overborrow. Secondly, this approach takes care of the exchange rate fluctuations to quite an extent. At least your loan repayment does not get complicated due to rupee depreciation. That your investment can lose value due to rupee depreciation is another matter. However, if you had to leave your job abroad or your income abroad gets compromised in any manner, then even this approach can cause you trouble.
#3 Look at Processing Fee and the Other Ancillary Charges
We have seen in an earlier post how processing fee and other loan charges can affect your cost of loan. If you have taken a loan abroad to make an investment, these charges will increase the cost of loan and will have a direct impact on net returns. Instead, if you have taken a loan to replace a rupee loan (that you would have taken), you need to account for such charges while assessing and comparing the all-in-cost.
#4 There Will Be Currency Conversion Charges
You have to incur cost in sending money to India. The bank will charge commission on the conversion. The banks typically charge a spread on the market rates. This also adds to the cost of loan. If you have to take this money back abroad, you will have to incur this cost twice. Do note there would be no such cost if you were to take a rupee loan in India.
#5 Consider the Impact of Tax-Breaks You Would Lose out On
It is unlikely that you will get a tax benefit for repayment of personal loan abroad. However, if you were to take a home loan or an education loan in India, you will get tax benefits on loan repayment.
To summarise, the loan interest rates abroad may be quite attractive as compared to rates in India. However, as I have mentioned many times before, understand what you are getting into. You need to look beyond interest rates. Assess the all-in-cost. Appreciate all the risks involved.