What Is the Real Cost of Your Loan?

You may be really excited to have negotiated a good interest rate for your loan with a bank. However, is the interest rate the only aspect in determining your cost of loan? What about the ancillary charges? Such charges also affect the cost of your loan, don’t they?



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FACTORS IMPACTING OVERALL COST OF LOAN
  1. Reducing Balance vs Flat Interest Rate

  2. Processing Fees

  3. Prepayment Charges

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Flat Interest Rate Loans vs Reducing Balance Loans

I have already written about flat interest rate loans and reducing balance (diminishing balance) loans. Clearly, even if you are getting a flat interest rate loan at a low rate of interest, you need to work out the numbers in spreadsheet. As we worked out in an earlier post, a flat rate loan (Rs 10 lacs, 5 years) at 10% was as expensive as a reducing balance loan at ~17% p.a. There are other charges too that can affect the cost of loan.

What about the Processing Fee?

Let’s consider the following two scenarios.

  1. Scenario 1: Loan of Rs 1 lac at 12% p.a. to be repaid in 3 years with a processing fee of 2%.
  2. Scenario 2: Loan of Rs 1 lac at 14% p.a. to be repaid in 3 years with NIL processing fee.

Both are reducing balance loans. I have assumed during the analysis that the processing fee is adjusted against the loan amount. Let’s see how processing fee impacts the cost of loan.

Amount100,000100,000
Tenure3636
Interest Rate12%14%
EMI3,3213,418
Processing Fee (%)2%0
Processing Fee + Service Tax (Rs)
23000
Net Loan97,700100,000
Month EMIEMI
13,3213,418
23,3213,418
33,3213,418
43,3213,418
53,3213,418
63,3213,418
73,3213,418
83,3213,418
93,3213,418
103,3213,418
113,3213,418
123,3213,418
133,3213,418
143,3213,418
153,3213,418
163,3213,418
173,3213,418
183,3213,418
193,3213,418
203,3213,418
213,3213,418
223,3213,418
233,3213,418
243,3213,418
253,3213,418
263,3213,418
273,3213,418
283,3213,418
293,3213,418
303,3213,418
313,3213,418
323,3213,418
333,3213,418
343,3213,418
353,3213,418
363,3213,418
IRR1.14%1.17%
APR (Annual Percentage Rate)13.63%14.00%

You can see processing fee of 2% has taken the cost of loan from 12% p.a. to 13.63% p.a? You can see the effective cost of loans is not too different despite a difference of 2% in the interest rate. And this is what these minor charges such as processing fee can do to your effective cost of loan. I could have chosen numbers to demonstrate the loan with NIL processing fee is a better choice. However, that is not the intent behind this post. The idea is to make you aware how such charges can affect overall cost of your loan.

Prepayment Charges

There are no prepayment charges for floating rate loans. But there can be prepayment charges for fixed rate loans. This charge is contingent. Unless you prepay the loan, there wouldn’t be such charge. How does this affect you? Many times, you take a loan merely to tide over short term cash flow mismatch. In such cases, you may want to prepay such loan when you cash flow position improves. Prepayment penalty is a deterrent used by the banks to keep you in the loan. After all, it makes little sense for you to stay in a high cost loan (post-tax cost) when you earn a paltry 4% in your saving bank account balance.

Let’s consider an example. You have two options.

  1. Case 1: Rs 1 lac loan, 12% p.a., 3 years. Prepayment penalty of 5% of outstanding balance.
  2. Case 2: Rs 1 lac loan, 14% p.a., 3 years. NIL prepayment penalty

Processing fee is NIL in both cases. Let’s suppose you prepay the loan at the end of  18th  month. What’s the cost of loan for you?

Amount100,000100,000
Tenure3636
Interest Rate12%14%
EMI3,3213,418
Processing fee0%0%
Processing Fee + Service Tax
Net Loan100000100000
Prepayment penalty5%0%
Month EMIEMI
13,3213,418
23,3213,418
33,3213,418
43,3213,418
53,3213,418
63,3213,418
73,3213,418
83,3213,418
93,3213,418
103,3213,418
113,3213,418
123,3213,418
133,3213,418
143,3213,418
153,3213,418
163,3213,418
173,3213,418
1860,51058,618
IRR1.17%1.17%
APR (Annual Percentage Rate)14.05%14.00%

Prepayment penalty takes the cost from 12% p.a. to 14.05% per annum. Note that effective cost depends on the timing of prepayment too. The sooner you prepay, greater the impact. I am not suggesting that you should opt for a high interest rate loan just to avoid pre-payment penalty. Moreover, it is difficult to tell upfront when you will exactly prepay. However, this is an aspect you must consider. If you plan to prepay, do consider prepayment penalty. Additionally, this is one part of loan agreement where you wouldn’t negotiate. Even the bank is unlikely to make any concession on the pre-payment penalty.

Conclusion

Do not go merely by the interest rate. Always consider the all-in cost. Remember the cost and charges may assume different names. It is your job to look into all the potential charges and assess the overall cost. If the charges are contingent such as prepayment penalty, consider its applicability in your case.



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