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