hometownSo my friend, let’s call him K, decided to go buy furniture and fixtures. He went to HomeTown and bought stuff worth Rs. 76021.

And then there was a Bajaj Finance advertisement that told him, oh, pay only 4% and get this on a loan!

So this is how they sold it to him. how-they-sell-it-to-you

Phenomenal deal, no?

K has to pay one advance installment – Rs. 6589, today. K’s EMI is just Rs. 6589 for 11 months. That’s a total of 72479, which along with the initial payment  adds up to just Rs. 79068.

You think – I’m buying stuff worth 76,021 but it’s only going to cost me another Rs.3,000 or so to take it on a loan! That’s just 4% (3,000 on 76,000)

(Okay, there’s also a processing fee of Rs. 1,100 but that only takes the interest rate to about 5.4% which is still cool?)

Under The Hood: The Actual Rate Is Closer To 9%

But that’s not how it works under the layers. Think of it like this:

  • You get some money as a loan
  • You pay an advance EMI so you actually get a lower amount as a loan (76021 minus the upfront payment of Rs. 6589 = a loan of 69432)
  • This amount is paid back every month through a monthly payment of Rs. 6589 for 11 months.
  • We have calculated that the interest rate is actually about 8.7% a year.
  • We start with an outstanding loan of 69432 in month 1. There’s some interest that applies to it for the month, at 8.7%, it would be Rs. 502.
  • We paid Rs. 6589 at the end of Month 1. That would take care of Rs. 502 of interest and reduce the principal outstanding to by 6087.
  • The new principal for month 2 is 63344.
  • The interest for month 2 is Rs. 458. (At 8.7%) And then you pay 6589, so the interest is paid out and the principal falls to 57,214.
  • And so on till, after month 11, your principal outstanding goes to zero.

Here’s how it works: how-it-actually-works

Now how did we get to 8.7% as the interest rate?

We tried using 4%. At 4% the loan would be fully paid off just around month 10. In fact, at 4% your monthly EMI would only be Rs. 5,000 – a full Rs. 1589 less!

We increased the rate until the outstanding became exactly zero at the end of 11 months. Which gave us 8.7%. That’s what you pay.

But isn’t 8.7% good? Not if it’s actually 12%.

Sure. But it’s not even 8.7%. It’s actually closer to 12%.

Because K had a processing fee of Rs. 1,100.

To get the loan he had to pay another Rs. 1100. Now let’s compare this to paying cash upfront. You would pay nothing – just the Rs. 76,021. Now you:

  • Pay Rs. 7689 upfront
  • Pay Rs. 6589 for 11 months

Using the same calculation as above, we realize that K actually paid 12% for the loan.

processing-fees

The finance folks here will complain that oh, you’re not ACTUALLY paying 12%, because the processing fee is just a fee and so on.

But it’s 12% really. Here’s why:

If you had Rs. 76021 and instead of taking a loan you kept the money (minus initial EMI etc) in a bank deposit or mutual fund, you would need an interest rate of 11.94% to actually pay this loan back at 6589 per month.

That’s why it’s 12%. The effective cost of capital, to you, is that much.

Note: It’s actually even higher if you have money in fixed deposits – because you’ll pay tax on the interest you earn, and cannot offset it against the interest you pay. It’s a mess and the salaried individual is the worst off in this debate.

Is Bajaj Finance making a killing? Well, they get the money from you. They also get a discount from the folks that sell you the furniture. And they pay out part of the “processing fee” as a commission to the agent. For them, net of everything, they probably rake in 15% or so. Which isn’t too bad, so one might just buy their shares. Also people love to hear 4% because it’s darn difficult to realize it’s 12%.

But What If You Don’t Have The Money?

This might still be useful because there are hardly any easy sources of loans that give you this cash at 12% or less.

We went to a Bankbazaar and put the amount in – for a 1 year loan of Rs. 76,000 you will pay just a little more (at 12.50%) per year. Notice that the numbers here look very close to the Bajaj Finance deal – only that the banks don’t pretend it’s 4%!

(They can’t. The RBI doesn’t allow them to. Bajaj Finance is an NBFC so they get to do these things)

other-personal-loans

(If you don’t mind the extra interest cost, banks love it when you take loans and repay them – they then give you future loans at 0% processing fees and/or lower interest.)

In reality, the 4% loan isn’t 4% – it’s actually 12%. But it still may be the lowest loan amount you can get if you don’t have the money. If you have the money, unless you’re getting a whopping 12% from it, it’s better to use your credit card, get some points, and pay off the credit card bill with the money.

Disclosure: Author owns some shares of Bajaj Finance. Author wishes he had a lot more shares, dammit.

Now, tell them about it: