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Smoke, Mirrors and Interest Rates

The hack that clears the air on loan offerings.

Ladies and Gentlemen, this is a public service announcement. Over the last couple of years, I’ve been both a keen observer, and now an active participant, of the lending market in India. I think there are some shenanigans going on.

Finance can be confusing at the best of times. It’s an area that touches all our lives, and yet most people will readily confess that they don’t feel comfortable, let alone confident, in many of the key concepts. It doesn’t help that it is riddled with jargon that is unintelligible to the uninitiated. It’s easy to be put off. It’s easy to be confused.

Is this deliberate obfuscation? I don’t know. Either way, let’s make things clearer for the benefit of us all. I’m not setting out to explain all of finance, but just one key aspect of lending: interest rates.

Let’s start with the fundamentals. In lending, the interest rate represents the cost of the loan. If you borrow a certain amount of money, the interest rate reflects how much additional money you need to repay over and above the sum you borrowed. The higher the rate, the more you have to pay back. One would reasonably think therefore that you can judge the attractiveness of a loan by simply comparing the interest rates of the various offerings available. The lower the rate, the cheaper the loan. Alas, life is never so simple.

I’m going to highlight 3 features present in the quoting of interest rates that make comparison difficult.

(I) Monthly vs. Annual Quotations

Most banks will quote interest rates on an annual basis. We are all used to seeing their ads for personal loans at starting at 10.99%. That’s an annual rate.

There are many lenders, particularly those focusing on shorter term loans, that quote rates on a monthly basis e.g. 2% per month.

There’s nothing wrong with this; there’s no rule, at least not in India, that specifies a quoting convention that needs to be adhered to. The question is, do you know how to compare offerings across the different formats? Most people think they do, but many are missing a trick.

The Tricky Trick We Almost Always Miss

Let me ask you this: what is 2% a month on an annualised basis? “That’s so easy!” I hear you cry. “I just multiply it by 12, so 2% x 12 is 24% annually”. It’s a good guess, but it’s wrong. What nearly everyone misses is compounding. This is something that deserves a post of its own, so I won’t go into details here, but let me just express the point that it’s the most powerful force in finance!

When you compound 2% 12 times (1.02 x 1.02 x 1.02…..) you find that your 2% a month becomes 26.8% rather than 24%. 3% per month is actually 42.6%. As you increase the monthly rate, the annual rate increases exponentially.

There are some lenders who focus more on adverse credit borrowers that charge 30% a month. This is not 360% per year, but 2,230%! Many of us have an intuitive feel for annual rates. This is not the case for monthly rates. It’s important to know what you’re really signing up for.

(II) Simple vs. Amortising balance rates.

Yes I know. Even the title of this section sounds intimidating. So before we delve too deeply into this, let’s take a step back for a moment. Why do lenders even charge interest? Thankfully this is pretty straightforward: they charge interest to compensate them for the risk that they are taking when they give a loan. They always have the option of keeping the cash and earning a risk-free rate on it. If they take risk, they need to get a higher return. In short, they need to earn a return on cash that’s gone out of the door.

Why Simple Is Not So Simple

Loan principal reduces with time

Ok, so this is where the games start. Let’s say you take a loan of Rs. 1 lakh, for 1 year, and you make repayments in the form of a monthly EMI. As you make your payments, your loan balance is reducing (this is called amortisation). Thus, the amount of interest that you need to pay per month will reduce, since you’ve got a smaller balance as time goes by.

EMIs are just a convenient tool that is widely used to make budgeting easier for all of us. Instead of having big payments at the beginning and small payments at the end, we all find it easier to know an amount that we have to pay every month. When we have equal payments, at the beginning we are paying a lot of interest and a little principal, and vice versa at the end. I don’t want to go too deep into this, but the graphic below illustrates what I’m trying to say. Importantly, on an amortising loan, you can see the loan balance reducing, and you are only paying interest on the amount that you’ve got outstanding.

Using the amortising balance method then, if you borrow Rs. 1 lakh, for 1 year, at an interest rate of 26.8% (2% per month) then you will pay a total of Rs. 1,13,472 i.e. 13,472 in interest.

Now let’s compare this to the seemingly innocuous “simple” or “flat” interest rate. Again let’s say that the interest rate is 2% per month. For our Rs. 1 lakh loan, that means you are paying Rs. 2,000 per month in interest

Interest is constant even though balance is reducing

every month. In this method, after half the loan tenor, half the balance has been repaid. Even as the loan balance is reducing, you are still being charged Rs. 2,000 in monthly interest. Do you know what this means? You are being charged interest on money that you’ve already repaid! Over the course of the year, you’ll pay Rs. 24,000 (2,000 x 12) in interest. Compare this with the earlier figure in the amortising method.

Instead of an annual 26.8% you are now paying a rate 51%. You are literally being charged almost double for your loan.

So be careful. 2% from one lender does not necessarily equal 2% at another.

(III) Processing and “Convenience” fees

Lenders will usually charge some form of fees when you take out a loan. There are costs associated with onboarding a customer so this makes perfect sense. But how much attention are you really paying to the amount you’re being charged in fees? Since you don’t know what they’re really for, you probably just accept them as they are. Instead, you focus your attention on the headline interest rate being charged by the lender when making your evaluation.

They Make The Winning Choice Obvious, BUT:

Let’s put this to the test. Again, suppose you want to borrow Rs. 1 lakh for 1 year. Which offer do you prefer?:

(A) 12% interest and 2.5% processing fee

(B) 14% interest and 1% processing fee

In this case option (B) is cheaper.

How about this:

(A) 12% interest and 2.5% processing fee

(B) 17% interest rate and no processing fee

In this case, the options are about the same.

Let’s be honest, in both examples, at first glance the best option is not obvious. Thus we turn to heuristics. We don’t really understand processing fees, so we focus on what we think we understand: the interest rate. Of course lenders understand this behaviour as well, so look out for headline grabbing offerings of low rates accompanied by fees of various forms on the high side.

Er…. What?

I will readily accept that after reading the three cases I’ve described so far, there’s a good chance that you’re just feeling confused. I recognise that I’m not really the best teacher. Luckily though, there is a way out. A hack that makes all of these complicated concepts go away.

Trust Cash, It Can’t Betray

15 years ago, when I was undergoing my analyst training as a fresh-faced graduate embarking on an investment banking career, one of our tutors imparted a sage piece of wisdom that is as true now as it was then. He said “cash is king”. In our context of a loan, you can forget all the complications with interest rates by just focusing on cash. Cash doesn’t lie. Cash doesn’t deceive. How much cash will you ultimately have to pay? Assuming you can afford the EMIs, the option that costs you the least is probably the best. Just go with the lowest number. In our earlier example where you’re borrowing Rs. 1 lakh for 1 year, clearly you’d prefer to pay Rs. 13,472 in interest rather than Rs. 24,000.

Loans have a lot of moving parts and can be complicated. Lenders don’t really have an incentive to clear the fog. Fear not. I would be perfectly happy if you forget everything I’ve written in this post, but take away one thing: cash is king.

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