When we are scouting for a loan, many of us focus merely on the interest rates. While the rate of interest is clearly the biggest head, you must not ignore other ancillary charges of a loan. The charges (and their nomenclature) depends on the bank/NBFC and also on the type of loan you are going for. Clearly, secured loans (such as home loans) are expected to have a longer list of charges as compared to an unsecured loan. For instance, a home loan can have application fee, processing fee, admin fee, technical evaluation fee, valuation charges, legal fees, pre-payment fee (for fixed rate loans only) and other penalties and fees. Some of the charges are absolute in nature while the others, especially the processing fee, is a percentage of the loan amount. If the charge is nominal absolute amount, the impact on your overall cost may not be very high. However, for the fee/charge linked to the size of the loan, the impact can be significant. Let’s look at how these charges can affect your overall cost of loan.
The Impact of Charges Is Higher in a Short Term Loan
For a short-term loan, the charges have to be spread over a shorter loan term. Let’s try to understand with the help of an example.
- A loan of Rs 10 lacs at 10% p.a. for a tenure of 3 years. The EMI for this loan is Rs 32,267.
- A loan of Rs 10 lacs at 10% p.a. for a tenure of 20 years. The EMI for this loan is Rs. 9,650.
Processing fee is 1% of the loan amount plus taxes in both the cases. Therefore, the fee will be Rs 10,000 + 18% GST = Rs 11,800. If you see, due to GST, the effective processing fee is 1.18% (and not 1%). Since GST is applicable on all kinds of fees, expect the impact to be a bit higher.
I have adjusted the loan amount by the upfront fee payable. Therefore, if the loan amount is Rs 10 lacs and the processing fee is Rs 11,800, your net loan amount becomes Rs 988,200. Of course, your loan EMI remains the same. Accounting for the processing fee, the net cost of a 3 year loan goes up to 10.82% p.a. On the other hand, the net cost of a 20 year loan goes up to 10.17% p.a. The impact for the shorter term loan is higher because the cost has to be spread over the shorter term. I did the analysis for different levels of processing fees.
|Loan Amount||Rs 10 lacs|
|Loan Tenure||3 years||20 years|
|Processing Fee||Net Cost||Net Cost|
You can see how the impact rises with the increase in processing fee. You may ignore this impact but your banker is always aware of the maths.
Consider the following two scenarios for 3 year loan.
- Loan at 10% with processing fee of 2%.
- Loan at 11% with waiver on processing fee
If you focus only on the interest rates, you will go with the first option, where the effective cost of loan id 11.65% p.a. Second option would have been a better choice even though it comes at a higher rate of interest. And banks can always play this trick on you. Reduce the interest rate but recover by hiking other charges. If you are not aware of the math, you are likely to fall for the trap.
A Few Contingent Charges May Affect Your Flexibility
A few charges may be contingent; i.e., you will have to incur those charges only on occurrence of an event. One such charge is pre-payment penalty. Pre-payment penalty is waived for floating rate loans. However, in case of a fixed rate loan, pre-payment penalty can be extremely high. If you have taken a personal loan or a car loan at a fixed rate, prepayment will have a cost involved and will add to your overall cost of loan. Personal loans and car loans are expensive loans. Loan amount is not very big. There are no tax benefit on repayment. Therefore, there is every incentive for you to try to close these loans. However, a pre-payment penalty can be a deterrent. From the perspective of the bank, that’s exactly the reason why such a clause exists.
Let’s consider an example. Loan amount: Rs 10 lacs, Interest rate: 10%, Tenure: 3 years. Pre-payment penalty: 5% of the prepayment amount (plus 18% GST). Let’s assume there is no processing fee or other charges. Let’s further assume that you try to prepay the loan after 2 years. At the end of 2 years, the outstanding loan amount will be Rs 3.67 lacs. Pre-payment penalty (including taxes) will be Rs 21,654. For a borrower, this hit is unfair. If you pre-close the loan after 2 years, the cost of the loan will come out to 11.35% p.a. (up from 10% p.a.). Clearly, the impact of contingent charges is difficult to assess accurately upfront. This is because you do not know upfront when you will prepay the loan.
What Should You Do?
Given a choice, go with the option that has the lowest overall cost (and not just the lowest interest rates). When it comes to contingent charges such as prepayment penalty, assess the applicability in your case. If there is a strong possibility of contingent event happening (say, you prepaying a loan), do weigh in those charges too.
Many banks waive processing fees for small periods. Of course, you can’t wait for the bank to waive off the processing fee before you apply for the loan. However, there is nothing wrong in keeping your eyes and ears open.
However, there is no excuse for not understanding all the loan charges before signing the dotted line. You can ask the banker for the list of all the charges. Go through the sample loan agreement to understand the contingent charges, if any.