Borrowing with least interest

This article we are giving an interesting case of 3 borrowers so that the concept of paying ‘least interest’ is well understood.

Mr. H, Mr. S and Mr. Y want to buy a car worth of Rs 5 lakh. They approach different financial institutions for a loan.

H is offered a loan of Rs 5 lakh with first six months as rest period. He will be required to pay 24 equal installments each of Rs 26,000 at the end of the month to clear the liability. The loan will be repaid at the end of 30 months. H has an additional cash inflow of Rs 26,000 every month, he accepts the proposals.

S is required to repay the loan with interest in 25 equal installments of Rs 23,000.

Y is asked to make a down payment of Rs 1 lakh and clear the balance amount in 40 equal installments of Rs 14,000.

Financial institutions often structure their products differently. It is difficult for a common man to find out the real cost of funds. Financial experts use intrinsic or internal rate of return (IRR) to compare various proposals. Generally, the proposal that gives the least IRR in the case of a borrowing is most preferable from the standpoint of the borrower. IRR is the effective rate of interest. Cash flows occurring at different times have different time values.

For example, one gets Rs 100 today. Another gets Rs 100 one year later. Though the absolute value of money in both the cases is the same (Rs 100), the value in the second case is less. If the first person can generate an income of Rs 10 on the Rs 100 received by him, he will have Rs 110 at the end of one year whereas the second will have only Rs 100. If the second person is given an option to receive Rs 90.90 at the beginning of the year or Rs 100 at the end of the year, and the person has capacity to generate 10% return per annum, then both the proposals mean the same thing to him. IRR eliminates such differences in time value of money and makes cash flows occurring at different times comparable.

In any loan proposal there is one cash inflow at the beginning of the loan period in the form of loan amount and several cash outflows occurring in the form of payment of interest and repayment of principal amount. Most of the times, interest and principal amount are aggregated and received by the lender in equal monthly installments known as EMI. IRR is the rate that equates the present value of the inflow with the present value of all the outflows.

In order to find out which loan suffers the least interest, we can use the technique of IRR. MS Excel gives a ready formula to find out IRR in such cases. One will find that the IRR in the cases of H, S, and Y is 1.297%, 1.105% and 1.754% respectively per month. Though the IRR in the case of H is greater than that in the case of S, H does not pay any amount in the first six months and he can deploy the money that he would have used in payment of EMIs elsewhere. This would reduce his effective cost of funds.

Though Y pays the highest interest, his installments are of a smaller size. Thus, one must select a financial product that suits one’s requirements.