You walk into a mobile store to assist your friend purchase a new mobile phone. You want to purchase your favourite phone (that costs Rs 50,000) too but your budget doesn’t permit.
Suddenly, a payment offer slapped across the mobile store grabs your attention.
What is the offer?
Under the offer, you can take an instant loan at 4% to fund your purchase. You can pay in 12 installments. You need to pay Rs 52,000 over 12 installments for a purchase of Rs 50,000 with an EMI of Rs 4,333 (Rs 52,000/12).
You pay Rs 2,000 over a purchase of Rs 50,000 over 12 months. That makes the cost 4% p.a..
Now, the phone does not look out of reach. And it isn’t expensive either. Where will you get loan at 4% p.a.? You get a better rate of return in your fixed deposit.
However, is the cost of loan really 4%?
When you calculate the interest cost, you do not just look at the quantum of cash flows but the timing of cash flows too.
Let’s consider the following aspects.
#1 You are not paying Rs 52,000 lump sum at the end of 12 months.
Had that been the case, the cost of loan would have actually been 4%.
But that’s not the case.
You are paying EMI every month. So, you have to pay first EMI at the end of first month, second EMI at the end of 2nd month and so on till the end of 12th month.
This minor adjustment takes up the cost of loan to 7.3% p.a.
#2 The First EMI is adjusted from the loan amount
Even before this change, the cost is already up to 7.3% p.a.
It will go even higher.
Typically, with such offers, the first EMI is adjusted from the loan amount. Effectively, you pay first EMI on day 1 itself (and not at the end of 1st month).
Your effective loan amount is not Rs 50,000 but only Rs 45,667 (Rs 50,000 – Rs 43,333).
You take a loan of RS 47,667 and repay it over 11 months in EMI of Rs 4,333 each.
This takes the interest cost to 8.65% p.a.
#3 Do not ignore the processing fee
Processing fee is almost always there with such loans.
How does the processing fee affect the cost?
Reduces the loan amount. The processing fee is adjusted upfront with the loan amount itself.
Let’s assume the processing fee was 1% of the purchase amount or Rs 500 (1% of Rs 50,000). Add to it service tax of 15%. That makes the impact of Rs 575.
Therefore, the effective loan amount becomes Rs 45,091 (Rs 50,000 – Rs 4,333 – Rs 575).
Effectively, you pay Rs 4,909 upfront and 11 EMIs of Rs 4,333 each.
If you repay a loan of Rs 45,091 in 11 EMIs of Rs 4,333 each, the effective cost of loan is 11.25% p.a. (and not 4% p.a.).
I am NOT joking
The cost is actually 11.25% p.a. If you don’t believe, here is the proof.
And increase in processing fee can increase the cost drastically. Cost of loan at processing fee of 3% will be Rs 16.58% p.a.
Clearly, the cost is higher than you were given to believe.
Such offers are loans after all. Therefore, just as for other kind of debt, affordability should be considered. Do not borrow unnecessarily. Do not borrow more than you can afford to repay.
Do note this analysis is not to refrain you from opting for such offers. Just that you must appreciate the cost of such offers before opting. Even a personal loan is likely to cost you more than 11.25% p.a.
These offers can be structured in many innovative ways on wide variety of items. If you must purchase the item (only you can tell), spare a couple of minutes on an excel sheet to assess the true cost and compare with other modes to fund this purchase.
You may have a bank fixed deposit of Rs 50,000 at 7% p.a. (and that too pre-tax). If you know the cost of loan is 11.25% p.a., wouldn’t you prefer to break the fixed deposit than opting for this offer?
CapitalMind: How a 4% loan for furniture costs you 12%?
EMICalculator: The Curious Case of 0% EMI Schemes