Loans – some facts

Lenders are packaging their loan products in such a way showing theirs involve the lowest amount of interest outgo from the persons taking their loans. All loan scheme particulars are the same that is loan amount, the loan term and interest rates etc., It is rare that the same loan particulars are not the same. You have ‘zero’ interest rate loans which indicate that there is a zero borrowing cost, when, the reality is quite different. These are mere beliefs which do more harm than good to a borrower in terms of the total cost paid on the loan. With a variety of consumer loans on offer, we are hurtling towards a more ‘Loan takers’ society to maintain the life styles.

Before availing any loans understand the loan scheme particulars to avoid falling prey to the lender schemes propaganda. There must not be any misconceptions about the on interest rates or loan repayment terms. Instead of blindly believing that floating interest rate loans are better than fixed ones, make an effort to understand the current interest rate scenario in greater detail. The method of calculating interest plays an important role in determining the total cost of a loan.

Following are some of the misconceptions on loans and suggestions to overcome the same:

A ‘Zero’ interest loan is the best

In recent times, ‘zero percent’ loan schemes have become extremely popular for car loans which usually do not have a large loan amount and a long tenure. However, in reality, under these schemes, one stands to lose the discount that he would have got if he had not opted for the ‘zero’ interest loan. This is because financers of such car loans avail heavy discounts from the dealers for purchasing specific car models and in turn offer the same to the borrower at the ‘ex-showroom’ price which is exclusive of the discount. The borrower do not gets the discount and financers make great gains as they pitch for a ‘zero’ percent loan. Apart from this the borrower has to pay up loan processing fees and documentation charges, which result in increased costs.

Loan with a longer term is better than a shorter term

EMI amount for a longer tenure loan is lower than that for a shorter tenure loan assuming that factors such as the loan amount, the rate of interest and method of interest calculation are the same, a longer tenure loan results in a greater financing cost. This is because the principal amount on a longer tenure loan is outstanding for a longer period of time. It therefore attracts more interest. This increase in the total financing cost is substantial if the tenure is significantly longer.

Floating interest rate loan is better than a fixed interest rate loan

A floating interest rate loan is one where the applicable interest rate moves in synchronization with the interest rate movements in the market. In case of a fixed interest rate loan, the interest rate remains stable during a part of or throughout the tenure of the loan.

A floating interest rate loan is highly beneficial every time there is a fall in the ‘benchmark’ interest rate, i.e. the rate to which the floating rate is linked. In case of most lenders, the Prime Lending rate (PLR) declared by the Central Bank of the country (for India it is Reserve Bank of India) is the ‘benchmark’ rate against which they link the interest rate on all their term deposits and loan products. Whenever the PLR rises or falls, the floating interest rate follows the movement. However, in a rising interest rate regime a floating interest is uneconomical.

Since interest rates have become volatile and unpredictable in the recent times, it is imperative to study the interest rate movement instead of taking it for granted that floating interest rate loans are better than fixed ones simply because the interest rate attached to them is generally lower by 50 to 100 basis points.

For a shorter tenure loan (such as a car loan, personal loan etc) a fixed rate might do more justice, particularly in a scenario of escalating rates. But one should be sure about lender’s definition of ‘fixed rate’ as it may be ‘fixed’ for only a part of the tenure of the loan.

Switch to a lower rate loan

Switching to a lower rate loan termed as ‘refinancing’ entails exiting from your present high-cost loan and taking a new loan at a lower rate. In most cases, this is not the best option since it may involve paying a prepayment penalty on old loan and processing charges on new one. This option should be considered only when the resultant savings in interest over the entire loan tenure is significantly greater than the one-time cost of switching.

Prepay a loan

It is always advisable to ascertain whether the funds that will be used to prepay the loan can be invested in instruments which earn returns that are greater than the cost of the loan. If so, then do not prepay the debt. Apart from this, the tax advantages associated with certain borrowings such as a home loan effectively reduce the total financing cost. If the loan is prepaid then one will not only forego the tax relief but also lose out on prospective returns if the money would have been invested in investments that offer higher post-tax returns vis-à-vis the cost of the loan.

A 10% loan from different sources is the same for all

Apart from the interest rate, the method of calculating interest plays an important role in determining the total interest cost payable on the loan. Lenders generally make use of the reducing balance method for levying interest on loans. Under this mechanism, interest is computed on the ‘principal outstanding’ on the loan. The principal amount outstanding on the loan reduces with every Equated Monthly Installment (EMI) that is paid and therefore, the more frequently the interest is calculated, the lower is the total interest burden. Lenders calculate the interest payable either on a monthly, quarterly, half-yearly or annual reducing basis.

The interest outgo on a ‘reducing balance’ loan would be highest under the annual rest and lowest under the monthly rest method. In short, in spite of two lenders offering an identical rate of interest, the total financing cost may differ greatly depending upon the method adopted for interest calculations.

Total cost of a loan is just the difference between the sum of all the EMI and the loan amount.

The cost of a loan is not simply how much you pay out in EMI over the duration of the loan, less the loan amount taken. Your total borrowing cost also includes the processing fees and administration fees charged at the time of taking the loan, prepayment charges (if applicable and if any), charges levied for late payment of EMI etc. The effective cost of a loan is determined only after you account for all these additional charges as well.