Interest rates in India are higher than many developed countries. A number of Non-resident Indians (NRIs) see this as opportunity to borrow at a low interest rate and invest in a NRE fixed deposit (NRE FD) at a higher interest, thereby netting the interest rate difference as profit. Things are never that simple.
There is a risk arising from potential depreciation of rupee. A minor depreciation can wipe out the profits from the structure and significant rupee depreciation can lead to losses. Most NRIs investors are aware of this currency risk (exchange rate risk) and are willing to live with this risk. This will not be the topic of this post either.
In this post, I want to highlight a different aspect. Sometimes, the low interest offered for a loan in your local country may not really be that low. Let’s try to understand this with the help of an example.
I was talking to a friend a few weeks back. He is an NRI and is based in Abu Dhabi. Over a phone call, he pointed out how he had availed a personal loan to profit out of difference in interest rates in India and UAE. He had taken a personal loan of AED 100,000 (United Arab Emirates Dirham) from a local bank at 3.72% p.a. and put the amount in an NRE fixed deposit at 8% p.a. He planned to repay the personal loan out of his local income. This way, he will be able to net 4.28% at almost no risk.
There is a Currency Risk
I pointed out that he was running a serious currency risk. It is quite possible that Indian Rupee may depreciate against the local currency. Such depreciation could wipe out the entire interest rate arbitrage (or supposed arbitrage) or even result in losses. He retorted that it could happen the other way round too. The Indian Rupee could appreciate against the local currency. In such a case, his gains will get magnified. He understood the risk and was quite willing to live with it.
As an investment adviser, I would not advise anyone to take loans to invest. However, my friend was quite confident and was aware of the currency (exchange rate) risk. He felt he had a big cushion of 4.28% to protect him against Rupee depreciation. We have seen how Rupee has depreciated (compared to USD) over the last 5 years. During 2010-2011, INR used to be around 40-45/USD and it is over 65 at present.
But who could convince him. According to him, I was too conservative. Anyways, since I am not a currency expert, I left it at that. Moreover, the ship had already sailed i.e. he had taken a loan and invested in an NRE fixed deposit.
I asked him about the EMI that he was paying. He told for a loan of AED 100,000 for 5 years, he was paying AED 1,977 per month. That makes it AED 118,600 for the whole tenor. Just by looking at the EMI, something didn’t look right to me. To me, it appeared a bit high. Since I am not that good at mental calculations, I left it at that.
The next day, I opened an excel sheet and tried to make sense of the numbers. At an interest rate of 3.72%, the EMI should have been AED 1,829 (and not AED 1,977).
Was he was offered a flat interest rate loan?
What is a Flat Interest Rate Loan?
Under a flat interest rate loan, total interest amount is calculated upfront.
Interest paid per EMI = (Original Principal Amount X Annual Interest Rate)/12
Principal Repaid per EMI = Original Principal Amount/ (Loan Tenor in years X 12)
Since the interest is calculated on original principal amount, the interest paid per EMI remains constant.
Hence, in this case, interest paid per EMI = 100,000 X 3.75%/12 = 310
Principal repaid per EMI = 100,000/ (5 X 12) = 1,667
Hence the EMI comes to AED 1,977.
This is in sharp contrast to reducing balance interest loans where interest per EMI is calculated only on outstanding principal balance.
What is Reducing Balance Interest Rate loan?
Typically home loan EMIs are calculated using this method. Under this method, interest paid is calculated every month on the outstanding principal balance.
Let’s see the difference between Flat Interest Rate loans and Reducing Balance Interest Rate Loan with the help of an example. I have considered the repayment schedule of an AED 100,000 loan at interest rate of 3.72% p.a.
I have not shown data for all the months as that would have been cumbersome. I hope you get the idea.
You can see the EMI is lower in case of reducing balance interest rate method since the interest is calculated on ever decreasing principal amount.
Actual rate of interest (internal rate of return) is 6.93% p.a. (and not 3.72%). Hence, the correct interest rate for comparison with NRE FD rate of 8% is 6.93%. The difference does not seem so much now, does it?
Who cares? I am still making a lot of money
My friend countered he is still making a lot of money. He will pay AED 118,600 in total. AED 100,000, if invested for five years at 8%, compounds to AED 146,932. So, he ends up making AED 28,382. At present exchange rate of INR 17.66 (per AED), this is equal to ~Rs 5 lacs. Why should he worry about whether the loan is flat interest rate or reducing balance interest rate?
This is merely an illusion
You will get AED 146,932 only at the end of 5 years, while you have to pay EMI every month for the next five years. What about the present cost of money?
Let’s assume you had not taken a loan and instead invested the EMI amount in an instrument yielding 6% p.a. At the end of 5 years, you would end up with AED 138,602. Of course, this assumes there is an instrument available which can yield 6%.
Now the difference is only AED 8,331 (146,932 – 138, 602). This is equivalent of Rs 1.47 lacs (at the current exchange rate). This is much less than the initial estimate of Rs 5 lacs.
Even this number is an overstatement
Banks typically charge a processing fee for such loans. Processing fees may vary across banks. Suppose, if the fee was 1% and was debited from your sanction amount, you will be left with AED 99,000 to convert to INR and invest in a NRE fixed deposit.
At the end of 5 years, you will be left with AED 145,463. The difference goes down even further to AED 6,861 or Rs 1.21 lacs (AED 145,463- AED 138,602). This is assuming exchange rate remains constant at INR 17.66/AED for the next five years and there are no conversion charges/commission for conversion from AED to INR and vice-versa.
Even this is exaggerated. What about the currency conversion charges?
Banks do not give you anything on the platter. To invest in a NRE FD, you need to convert AED to INR. Bank will charge some commission on converting AED to INR i.e. your conversion will not happen at INR 17.66/AED. It may happen at say, INR17.50/AED. If you need to take money back after 5 years to your local country, you will again have to pay conversion charges. The conversion may happen at say INR17.80/AED.
If you take this into account too, NRE FD at maturity and conversion to AED will yield AED 143,011.
So, the difference goes down even further to AED 4,410 or Rs 77,884 ( AED 143, 011 – AED 138, 602). The profit from the entire deal is down Rs 77,884 (We had started with Rs 5 lacs).
And we have not even considered risk on account of rupee depreciation. I will advise NRIs against doing such transactions. You run a huge currency risk in such transactions. If you have decided to take the currency risk, be aware of the type of loan you are going for. Flat rate interest loans are used as a marketing tactic to attract customers. However, it is your responsibility to delve into the details and get the numbers right.
By the way, my friend is still not convinced. As an adviser, there is only so much I can do.
Image Credit: Steven Byles, 2010. Original Image and information about usage rights can be downloaded from Flickr.com
Deepesh is a SEBI Registered Investment Adviser and Founder, www.PersonalFinancePlan.in
18 thoughts on “NRI Corner: Interest Rate Arbitrage is not without risk”
Very nice article Deepesh. Good work. Helpful for investors as well as advisors!
Thanks Abhinav!!!
Dear Deepesh,
As an NRI having a lump sum amount. What you will advice, where to invest in Mutual Fund..considering current market situation..
Regards
Syed
Hi Syed,
I cannot comment on market situation.
Suggest you seek professional investment advice.
Quite an eye opener. As usual, Deepesh your explanation was simple & lucid. Some of my friends here in Singapore do this. And, as said they only look at the face value of the interest rate and not how the rate is calculated. Also in the hullabaloo of profits being made nobody bothers to check on processing fees and other small charges.
But more importantly as is aptly pointed out, actually everybody looks at very short term and forgets to take currency fluctuations risks into account. This type of currency arbitrage could be risky.
Thanks Nandan!!! I have never been in favour of such arbitrage.The currency risk is too high. We have discussed such things. Yes, ancillary charges add to the cost too.
Yes, but interest part also include insurance cost for loand and it can be 0.5 ^%
That can be for specific loans. Can’t be generic.
Insurance will be for covering lender’s risk (if borrower dies or fails to repay loan).
In any case, the post was more about flat rate vs diminishing rate and the currency risk in doing arbitrage.
No insurance covers this risk.
Sir
Just a clarification regarding Insurance Cost. Banks in UAE who grant personal loans ask the borrower to pay additional percentage to cover the insurance cost. Insurance is of two fold one to cover in case the borrower dies and in some cases if the borrower loses his job. The bank where I work, taking insurance for personal loan is mandatory. We also have options to take insurance to cover our credit card outstanding as well.
Regards
Ninan
Dear Sir
Your article on returning NRI was an eye opener to me. Thanks for the same. With regard to this article. I agree to what you say in general but one or two factors which should be considered.
1. An NRI mindset especially people who work in the Gulf is to make as much capital (savings) as possible and return back to India as there is no permanency in this part of the word unlike in USA or any European Country. In this context, Interest rate on NRI FD is a major factor for decision making. Example – Few years back, Banks were offering NRI FDs at 10% p.a. The rate has gradually reduced over the period of time. I have borrowed money at 4.5% on diminishing balance and invested the same in FD at 10%. This rate has now fallen to 7.50 or in some banks 7.25%. It should be noted that the primary source of repayment of the FCY loan is from my regular savings and hence technically there is no loss in converting the money back to AED. If I had not taken the loan and booked the FD at 10% and instead gone by regular remittance as and when I get my savings, the FD which I am now opening will be at 7.25% and would have lost out on the 10% FDs.
2. As long as the intention of the NRI is to settle down in India, and not to convert back the NRI FD back to FCY to repay the loan, there is no technical loss. The loss is only notional. When I came to Dubai, exchange rate was 1 AED to INR was 6. Now it is 18. But this is only notional as I have continued to save and got rates as high as 24% when the economy was in a bad state as in 1995 to 96. At that time, deposits were getting doubled in 4 years time for NRI deposits.
3. Also it is not easy to get diminishing balance loan in FCY (like I managed). Most of the loans in this part are fixed rate loan as you have rightfully mentioned and clients should be careful in knowing this. My advise is instead of taking these loans were the differential is small, go in for Recurring deposits. When the NRI deposit rate was 10%, I have also booked few recurring deposits for smaller amounts.( multiple deposits) This ensures that my monthly remittances are routed back to the high interest recurring deposits which I had booked as the rate is locked until maturity.
Right now, my recurring deposits rate is 10% and 9.5% whilst the current NRI FD is only 7.25%. This is another way where you can lock in your NRI deposits at higher rates without taking any loans and going for arbitrage.
3. The third advise which I generally give to our NRI friends is that always go for long term deposits minimum 10 years to lock the high interest rate. However, ensure that accrued interest is paid by the bank on these deposits on a quarterly basis. This ensures two things – 1. Interest rate is locked for the next 10 years despite the current market rate where interest might fall. 2. In case the NRI interest deposit rates increase after two years of placing your deposits, you can always negotiate with the bank and ask them to move the deposit to higher rate and as long as the deposit will remain with the same bank, most of the banks will oblige without charging penalty rate.
4. When you go for long term FDs remember to book recurring deposits as well. The reason being as and when you get quarterly interest, this amount should be channeled back to the recurring deposits. This way, due to uncertainty and if you loose your job, you have a steady cashflow by way of interest coming to your account on a quarterly basis instead of waiting for interest until maturity at the same time if you continue with the job, this surplus is channeled to the high interest rate recurring deposit.
5. Last but not the least, as a conservative chap, to medium risk takers I advise that the accrued interest instead of channeled to recurring deposit can also be put as SIP to buy Mutual fund. This way, your capital is protected by way of NRI deposit and only your interest is used for investing in MF which is high risk category of investment and over a period of time will give higher returns.
Sir, hope you like my suggestion and thank you for your articles.
Ninan
Dear Sir,
Thanks for your inputs. Your experience speaks for itself.
The idea is to be aware of the risks involved. I am sure many people are not.
Without the awareness, you might feel it is an arbitrage while it is not. Currency risk is there.
In your case, you are sure that you can repay loan abroad through your cash flows or through your local savings. With others, this may not be the case.
I do not deny that there might be an opportunity but risk can’t be ignored.
Hi Deepesh,
Thanks for this interesting article, I am also planning to make use of interest rate arbitrage but not for investment in India but to pay off my education loan (11.25 %) using personal loan (3.9%) from an European country.
Could you please provide your valuable insights in my case?
Thanks,
Gaurav
Hi Gaurav,
In that case, the risk is much less. You have converted loan amount (to Indian Rupee) to repay rupee loan.
Subsequently, your liability is in foreign currency and your income is in the same currency.
You have not made any investment in India (and thus you do not plan to use return from Indian investment to repay foreign currency loan) Hence, you are not exposed to rupee depreciation.
Hi Deepesh,
Thanks a lot for your insight. I was worried about low exchange rate for EUR-INR conversion at the moment, but I guess it wont improve in the near future. So I think it makes sense to pay off high interest loan with loan interest loan.
Keep doing the great work!!
Cheers,
Gaurav
Hello deepesh. The major risk in interest rate arbitrage seems to be changes in exchange rates.. can the solution to this be booking /freezing the liability by way of forward contract So that the customer now knows the exact out go when he repays the banks.(Covered Interest Rate Arbitrage). Pls suggest
Hello deepesh. The major risk in interest rate arbitrage seems to be changes in exchange rates.. can the solution to this be booking /freezing the liability by way of forward contract So that the customer now knows the exact out go when he repays the banks.(Covered Interest Rate Arbitrage). Pls suggest
Hi Apurva,
Yes, I agree. That is an option. Even banks pitch this solution to their clients.
Just that if the forward position goes against you (by a big margin), the bank can foreclose FD.
Hi Apurva,
Yes, I agree. That is an option. Even banks pitch this solution to their clients.
Just that if the forward position goes against you (by a big margin), the bank can foreclose the FD.