“Get cash at 0.99% per month interest for 12 months on your card no XXXX 1234. Call 1800 XXX YYY or call on (022) 1234 5678 or SMS CASH on XYZ. Conditions apply from: XYZ Bank.” I recieved this SMS a few minutes ago. Mr Mohan Kumar also received this message, but unlike me he bit the bait!
I must admit that the offer is quite enticing: money at 0.99% per month, that too, from a credit card company. Many of us fall for such utterly misleading advertising. In fact this is a cheap, disgusting way of marketing loans.
Unfortunately most banks believe that this is ethical and do it all the time. They think that consumers are stupid and don't understand the basic mathematics behind this game.
To our misfortune regulatory bodies like RBI, SEBI etc don't seem to have any problem with lenders who fool innocent consumers. In my opinion this is a heinous crime. Here's a dissection of the real cost of seemingly cheap deals.
Money @ 0.99% per month!
This figure amounts to 11.88% per annum and Mr Mohan thought to himself -- his bank was giving him a personal loan at 18%, so naturally this was a very good deal. Mr Mohan is told that this is a reducing balance loan. So, each month he will pay less interest.
This fact is correct but presented wrongly. If the part principal is being repaid each month why should anyone pay interest on the whole loan amount? It is a reducing balance loan and that is the way it should be.
So, so why use it like a punchline or a USP? Let's understand how this loan at 0.99% per month actually works by a layman's calculation.
* Say the loan is for Rs 5 lakh, for a 48-month period, the EMI being Rs 15,368.
* You will totally pay Rs 15,348 X 48 = Rs 737,664 against your loan of Rs 5 lakh.
* That is Rs 237,664 extra as interest over 48 months ie four years.
* That is Rs 237,664 divided by 4 = Rs 59,416 as interest per year.
* Thus Rs 59,416 divide by Rs 5 lakh = 11.88% and thus 0.99% per month.
Things could not be represented more wrongly!
The correct way to do this is to use a concept called Internal Rate of Return (IRR) as it is the IRR, which is the ‘real rate’ the bank is charging you.
Now, let's calulate cash flow for the bank as follows:
Time From the lenders perspective
Time = 0 (now) Rs 5 lakh outflow
Time = 1 Rs 15,368 as inflow
Time = 2 Rs 15,368 as inflow
Time = 3 Rs 15,368 as inflow
Till Time = 48 Rs 15,368 as inflow
In mathematical terms, the IRR of the series of cash flows shown above works out to 20.57%, that's almost 21% pa against the 0.99% per month claimed by the bank!
This is told to you only if you ask what is the IRR or the effective rate of interest.Generally you are never told this. The real cost of this 'cheap' loan is 20.57% pa!
Further more, Mohan was told that to avail this facility he will have to pay only 2% of the loan amount as processing fee and that will be charged in the first statement.
Now a 2% processing fee works out to Rs 10,000. If you account for this amount the bank’s IRR now moves up to 21.72%! So, you take the loan assuming interest rate at 0.99% per month, that is 11.88% per annum when the lender is actually earning 21.72%. But this is not it -- you still need to pay more!
The bank levies a service tax of 12.36% on processing the fee, which it needs to pay to the Government. This works out to Rs 1,236. Factoring this into your cost, increases the bank's IRR to 21.86%.
Further more, you need to pay service tax @ 12.36% on the interest component of your EMI, too. Many banks don't tell you this, and the extra charge turns up in your loan or credit card statement. Now, add this and your cost increases to an astounding 24.56%!
So, the next time you see a loan deal coming your way at say 12% per annum think again. The 'real cost' to you is easily double of that, to say the least. It's worse if you have taken it from a credit card company. The reason: if you forget or delay to make even one payment the bankers will rejoice -- you have a late fee plus about 3% more interest as penalty on the outstanding amount, plus service tax on the above.
No free lunches!
If we are told that the cost of this loan is 25% per annum and we agree to it, then it's fair. What really pinches when we are misguided and information is not correctly and openly given to us.
In this case the bank and its officers via their bonuses, commission and salary, are making money completely at your expense and many a time unethically by not guiding us correctly. To me, this is unfair. But this practice is rampant, and no one seems to have a problem with it. But remember: there's no such thing as a free lunch. And this is especially true in the case of money.
Now, I hope you wouldn't be as careless as Mr Mohan Kumar was.
