You take a personal loan of Rs 2 lacs from a bank. Interest rate is 10% p.a. What is the cost of the loan? 10% p.a., right? Isn’t interest rate the cost of loan? Yes, but only if the bank levies no other charges. If the bank does levy additional charges, then the cost of the loan will depend on the quantum of such charges and the loan tenure.
This is best understood with the help of examples.
| Loan Amount | 200,000 | 200,000 | 200,000 | 200,000 |
| Interest Rate | 10.0% | 10.0% | 10.0% | 10.0% |
| Tenure (Months) | 6 | 6 | 6 | 6 |
| Processing fee | 0% | 1% | 2% | 3% |
| Processing fee (incl. GST) | – | 2,360 | 4,720 | 7,080 |
| EMI | 34,312 | 34,312 | 34,312 | 34,312 |
| Effective Cost of Loan | 10% | 14.1% | 18.4% | 22.7% |
I have assumed that the processing fee is adjusted with the disbursed amount. In other words, the bank disburses the Loan Amount – Processing fee.
As you can see, as the processing fee goes up, the effective cost of loan also goes up. It is not just 10% anymore.
| Loan Amount | 200,000 | 200,000 | 200,000 | 200,000 | 200,000 | 200,000 | 200,000 | 200,000 |
| Interest Rate | 10.0% | 10.0% | 10.0% | 10.0% | 10.0% | 10.0% | 10.0% | 10.0% |
| Tenure (Months) | 12 | 12 | 18 | 18 | 36 | 36 | 60 | 60 |
| Processing fee | 1% | 2% | 1% | 2% | 1% | 2% | 1% | 2% |
| Processing fee (incl. GST) | 2360 | 4720 | 2360 | 4720 | 2360 | 4720 | 2360 | 4720 |
| EMI | 17,583 | 17,583 | 12,011 | 12,011 | 6,453 | 6,453 | 4,249 | 4,249 |
| Effective Cost of Loan | 12.2% | 14.5% | 11.6% | 13.1% | 10.8% | 11.6% | 10.5% | 11.0% |
An interesting point here. The impact of processing fee on the overall cost of loan goes down as the loan tenure goes up. Why? Because the same quantum can be spread over a longer duration.
Why Are We Getting into Mathematics?
Because it is important to compare various loan offers. The banks are smart. Can trick you by offering a low rate of interest and charging a processing fee.
Which loan is better?
- Rs 1 lac. Loan Tenure: 6 months. Interest rate 9%. Processing fee of 2% + GST OR
- Rs 1 lac. Loan Tenure: 6 months. Interest rate: 10%. Nil processing fee.
If you focus just on the loan interest rate, you will pick the 1st option.
| Loan Amount | 200,000 | 200,000 |
| Interest Rate | 9.0% | 10.0% |
| Tenure (Months) | 6 | 6 |
| Processing fee | 2% | 0% |
| Processing fee (incl. GST) | 4,720 | 0 |
| EMI | 34,214 | 34,312 |
| Effective Cost of Loan | 17.4% | 10.0% |
However, you can see that the first option has a lower EMI but a higher cost. You pay a lower cost (despite a higher interest rate) in the second option. Since the tenure is the same, we can also compare the total payout.
- In the first option, you pay Rs 34,214 X 6 + Processing fee = Rs 210,002
- In the second option, you pay Rs 34,312 X 6 = Rs 205,873
The processing fee (in the 1st option) messed everything up.
The banks may not always be too upfront about the processing fee at the time of application. You may also focus on the interest rate (and ignore the processing fee). You may find out about the processing fee when the bank finally disburses the loan after adjusting for the processing fee. Even if you were to figure this out a day before the loan disbursal, you have already committed mentally and expended so much time and effort that you do not want to get out.
But What if You Can’t Do so Much Math?
It is not easy. Not everyone can open a spreadsheet and perform these comparisons.
The good part is that the RBI is aware of these issues. That banks can play smart and that most borrowers can’t calculate.
Hence, the RBI Government in his Monetary Policy statement on Feb 8, 2024, noted the following:
The Reserve Bank has mandated the banks to provide an all-inclusive annual percentage rate (APR) to all borrowers in Key Fact Statement (KFS). Earlier, this was mandated for only the digital loans and certain other loans. Now, this has been extended to all retail and MSME loans.
Reproducing an excerpt from RBI’s Statement on Developmental and Regulatory practices:
Hence, this move is borrower friendly. However, there is another problem. I am not too sure when this Key Fact Statement (KFS) will be issued. At the time of application OR after loan sanction?
With respect to the problem about the effective cost of loan that we discussed, the RBI move is helpful if the KFS is shared at the time of loan application. If the KFS is shared after all the formalities are completed, it does not serve as much purpose (for the problem under consideration).
Hence, it still helps if you develop some comfort with Microsoft excel. A little bit of math does no harm.
Additional Reading
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