You invest Rs 1 lacs per annum for 10 years. You would get Rs 2 lacs for 10 years from the end of the 11th year. Is this a good investment or a bad investment?
I advise many investors on their portfolios. Many of them have purchased poor investment products but they are still happy with these choices. The return from the above investment product is 6.5% p.a. I don’t want to get into argument on whether 6% or 7% p.a. is a good return or not. The point is that these investors didn’t even go to the return calculation part. The focus was simply on what I invest and what I get back.
Frankly, it is the limitation of our brains. We can do only very simple calculations in our head.
What is 9 times 7? Most of us can answer quickly without needing pen and paper. However, if I were to ask you, what is 97 times 79? Most of us would open calculator app on our mobile phones.
It is not easy for us to work out the IRR of the above mentioned investment product easily. You can’t even do this in your mobile calculator. Not many are comfortable with spreadsheets. Therefore, we decide on the basis on what we can easily absorb or appreciate. Getting back Rs 2 lacs per annum from the end of 11th year for 10 year is easier to understand. And that’s how most of us make investment decisions.
What about Loans?
By the way, we don’t just do this with investments. Don’t we do this with our EMIs too? Most of us don’t understand the working behind EMI calculations. And I doubt anyone can do these calculations without a calculator or at least a pen and paper.
We appreciate the loan quantum and interest in the form of EMI only. EMI depends on the loan amount, interest rate and the loan tenure. We appreciate the affordability of loan from the size of EMI. The banks do exactly the same. There is nothing wrong too. After all, EMI is what you must pay. And it is easier to understand the impact of hike or cut in interest rate through changes in EMI. Rate going up from 8.5% to 9% means nothing unless we see the impact on EMI (we ignore the adjustment in loan tenure).
However, many high cost loans can hide the cost behind the mask of monthly payments. The lender (especially online lenders) may advertise the low monthly payment and make no mention of the APR (or the loan interest rate). This is a red flag for you. This is quite likely for online lenders and loan apps.
For instance, if a loan is such that you get Rs 1 lac, but you have to pay Rs 8,000 per month over the next two years. You need Rs 1 lac urgently and you think you can pay back Rs 8,000 per month for the next 24 months. That’s it. You may never go beyond this. If the lender were to focus on the fact that the interest rate for such a loan is 72% p.a., you would perhaps have stayed away. Or perhaps you would have still gone ahead. That would have depended on the urgency and your other loan options. However, it would have still been an informed decision.
Related: Use our Loan Interest Rate Calculator to calculate interest rate and APR on your loan.
The lender may conveniently hide the interest rate information at the time of signing up. Interest rate information may still be there, but no lender shows the impact of processing fee on the overall cost of loan. We know that the processing fee can have significant impact on the cost of your loan, especially the short-term loans.
What Should You Do?
The cheaper the loan, better it is for you. However, low EMI does not mean a low-cost loan. We know EMI will reduce as we increase the loan tenure.
Which is a lower cost loan?
- A Rs 1 lac loan (20% p.a. , 2 year loan tenure) will have an EMI of Rs 5,089.
- A Rs 1 lac loan (30% p.a., 5 year loan tenure) will have an EMI of Rs 3,235.
If your criterion is EMI, the second option is cheaper. If your criterion is interest rate, the first option is better. If your criterion is total interest paid, the first option is better. You pay ~ Rs 22,000 in interest in the first loan and Rs 94,000 in interest in the second loan.
By the way, in some cases, you might want to pay a higher cost loan for a shorter duration than a not-so-high cost loan for a long duration. What would you prefer 30% loan for 1 year or 20% loan for 5 years? No fixed answer. Will depend on many things.
Coming back to the topic, if you focus only on the monthly payments, you may not even notice that you have taken a very expensive loan. If you are desperate for quick cash, there is little you can do. You have to go with whatever is offered. However, if you have time and can take a step back to understand the true cost of loan, you can save yourself some money.
The numbers can sometimes fool us.
However, high interest rates may not always be evil. High interest can reflect higher repayment risk. Moreover, the lending business needs to be viable after financing and operational costs.
By the way, even the highest rates in the formal finance sector are no match to rates in the informal market. Ask those who borrow from local moneylenders. The rates can go as high as 100% per month. Ask the vegetable vendor who borrows Rs 1,000 from the local lender in the morning and must return Rs 1,100 in the evening. Try calculating the annual rate of interest in this case.