Why No-Cost EMI Can’t Be for Longer Tenure?

Loan interest rates have been going down over the past 18 months. It is also evident in the examples that we use for various illustrations in our posts. Earlier, we used 9-10% p.a. for long term loans. Now, we use 7-8% p.a. in the illustrations. If you use Amazon or Flipkart, you would have noticed that if your purchase exceeds a certain threshold, you can purchase the product on EMIs. Of course, you need to own a credit card from a partner bank.

A friend had 2 questions on the EMI purchases.

1. Why No-cost EMI is not available for longer tenures? You will see these loans for only up to 6-9 months. If you want a longer duration loan, you must opt for a regular loan (interest-based).
2. For those interest-based loans, the interest cost has not come down. It was 13-15% p.a. before. It is 13-15% p.a. even now. Shouldn’t the rates be lower for such loans too?

The answer to the first question is quite crisp. The answer to the second question is a bit subjective.

About No-cost EMI loan, a loan of longer duration will be unaffordable to the bank/e-tailer/seller. We have discussed this before in a post on No-cost EMIs. A quick brief of how No-cost EMIs work.

No-cost EMIs are regular interest-based loans. In fact, zero interest rate loans are not permitted under RBI regulations. To provide a no-cost EMI (zero interest rate) experience, you are offered an upfront discount equivalent to interest cost.

Let us say you make a purchase of Rs 50,000.  You opt for 6-month No-cost EMI. You will pay Rs 8,333 (50,000 / 6) for 6 months.

Now, the upfront discount will be calculated such that the EMI comes to Rs 8,333.

If the bank uses an interest rate of 15% for the loan, it can easily do a back-calculation to figure out the discount.

Interest rate =15% p.a., Tenure = 6 months, EMI= 8,333

You can use the PV function in excel to figure out the loan amount.

PV (15%/12, 6 months, 8,333,0,0) = Rs 47,883

Upfront Discount= Rs 50,000 – Rs 47,883 = Rs 2,117

You will be given this upfront discount. Your credit card will be charged only Rs 47,883.

Hence, an upfront discount, followed by a regular interest-based loan gives a No-cost EMI experience.

Now, the question to ask is — Who bears this upfront discount? While I cannot say with certainty, it is likely shared between the seller on Amazon / Flipkart and the bank, with the seller likely forced to share bulk of the responsibility.

How is all this math relevant to our original question?

#1 Why No-Cost EMI Option Is Not Available for Longer Tenure?

This is relevant because the upfront discount depends on the loan tenure.

No-cost EMI Tenure	Upfront Discount
3 months	Rs 1,224
6 months	Rs 2,117
9 months	Rs 2,986
12 months	Rs 3,836
18 months	Rs 5,473
24 months	Rs 7,032 (which is 14% of item cost of Rs 50,000)

And someone needs to bear that cost to provide you No-cost EMI experience. As the loan tenure of No-cost EMI loans increases, the quantum of upfront discount goes up. Such a high discount may not be sustainable. For this reason, no-cost EMIs are usually for shorter tenures.

#2 Why Has the Cost of Regular EMI Loans Not Gone Down?

Its still around 13-15% p.a. I cannot comment on this aspect with certainty, but I will try to present an argument.

I think this is because the banks do not charge a processing fee on these loans. With no processing fee, the interest rates must be higher to adequately compensate the banks. We have discussed before that the processing fee impacts the overall cost of a short-term loan in a significant way.

Continuing with the above example, let us go with a regular loan for 24 months (Interest:15% p.a., Loan Amount: Rs 50,000, Tenure: 12 months). EMI will be Rs 4,513. Over the next 12 months, the bank will earn total interest income of Rs 4,154 (4,513 x 12 – 50,000).

If the bank could charge a processing fee of 2%, to earn the same amount of income, it would have to charge only 11.45% p.a. (instead of 15% p.a.). In this case, the bank is not charging any processing fee, hence the interest rate must be kept higher. We must also note that credit card loans are unsecured loans and hence must be priced accordingly.

Please understand that I am not defending the banks’ decision to charge high interest rate on credit card loans on e-commerce websites. I cannot comment on what is an adequate compensation for banks in a loan. As I see, small ticket loans for short tenures yield very little interest income in absolute terms. Therefore, for such loans, in absence of processing fee, a higher interest rate is perhaps the only way to make this a fruitful engagement for the bank.