When we plan to take any loan, we usually try to shop for the lowest rate of interest. That is a good strategy since the interest forms the biggest component of cost for any loan.
However, interest cost is not the only cost that you need to bear to service a loan. There may not many other charges with different names. Some charges may be expressed as a percentage of the loan while others may be absolute.
There is processing fee. There are technical, valuation and documentation charges. The nomenclature may vary. However, each of these charges adds to the effective cost of your loan.
While assessing the true cost of your loan, you cannot ignore these charges.
Banks are smart. They can offer you a lower rate of interest but hike other charges to effectively negate the lower rate of interest.
If you only focus on the rate of interest, you will fall into this trap.
The impact of charges (other than interest) will be higher for:
- Shorter term loans (as compared to long tenure loans)
- If the charge is absolute (and not a percentage of the loan), the impact will be higher for low-value loans.
The hit is higher for shorter-term loans
Let’s try to understand this with the help of an example.
- A loan of Rs 5 lacs with a loan tenure of 3 years at 9% p.a. EMI is Rs 16,133
- A loan of Rs 5 lacs with a loan tenure of 20 years at 9% p.a. EMI is Rs 4,825
Let’s further assume that the processing fee for the two loans is 1% of the loan amount. Since the loan amounts are same, the fee in both the cases will be Rs 5,000. Add GST of 18%, the fee becomes Rs 5,900.
Let’s see the impact of this processing fee on the net cost of the loan for various levels of processing fee. I have assumed that the processing fee (including taxes) gets debited from the disbursed amount. Therefore, the net loan goes down.
You can see the impact is much higher for the 3-year loan.
At processing fee of 1%, the cost of loan has gone up from 9% p.a. to 9.81% p.a. Isn’t that huge?
For the 20-year loan, the cost of the loan goes up to 9.17% p.a.
The hike in net cost is much higher for the shorter tenure loan because the impact of processing fee is spread over a much shorter tenure.
Banks are always aware of such maths. You should be too.
Armed with this knowledge of numbers, banks can make smart offers (better for the bank) to you.
Let’s compare the following two offers from Banks A and B.
Bank A: A personal loan with interest rate of 9% p.a. for 3 years with 2% processing fee
Bank B: A personal loan with interest rate of 10% p.a. for 3 years with NIL processing fee
If you focus only on the interest rate, you will go with Bank A. However, we have seen above that, with 2% processing fee, the effective cost of the loan is 10.64% p.a.
You should have gone with the offer from Bank B.
Point to Note: GST does not go to the bank. These charges have to be passed on to the Government. Therefore, the cost of the loan for you may be higher the income from the loan to the bank. However, I believe you got the idea.
To get to sign up, a bank can always reduce the rate of interest and recover extra money in the form of charges.
Absolute charges will impact low-value loans more
Typically, the charges are expressed as a percentage of the loan amount. However, if a charge is expressed is absolute (fixed), the low-value loans will see a greater impact.
The reason is obvious. The charge is recovered on a lower loan amount.
If there is charge of Rs 1,500 (including taxes)
The cost of Rs 1 lac loan (9% p.a. , 3 years) will go up from 9% to 10.04% p.a.
The cost of Rs 5 lac loan (9% p.a. , 3 years) will go up from 9% to 9.21% p.a.
Contingent Charges will have an impact too
Contingent charges are applicable when an event happens.
One such charge is Pre-payment charge. This charge is applicable when you try to pre-pay your loan.
As per RBI guidelines, there are no pre-payment charges for floating rate loans.
However, banks may levy such charge/penalty in case of fixed-rate loans. Such penalties add to the cost of the loan.
You take a loan of Rs 10 lacs at 10% p.a. for 5 years. You choose to prepay the entire loan amount after 2 years. At the end of two years, your total loan outstanding will be 6.58 lacs
If the prepayment penalty for your loan is 3% of the prepayment amount, the prepayment penalty (including GST) will be Rs. 23,309.
With this payment, the effective cost of your loan will be 11.23% (and not 10% p.a.)
It is difficult to assess the impact of such charges upfront. You may not be sure if and when you will prepay the loan. However, if you have plans to prepay your loan, do look into the quantum of pre-payment penalty before finalizing the loan.
Penal interest and late payment charges are another set of contingent charges. Frankly, you shouldn’t take a loan if you have to worry about such charges even before you take a loan. However, if your cash flows are erratic and you foresee such a scenario, it is something you must ponder over.
The key is to go for the lowest cost loan product (and not just the lowest interest rate). Under the all the charges involved before signing up. You can also go through the sample loan agreement to understand the charges better.
Assess the applicability and impact of contingent charges in your case.