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(Precious) Words of Wisdom : "The art is not in making money, but in keeping it." ~ Proverb

BEWARE!! 8% = 14.68%

I got a call from a bank offering me loan at 8% flat interest rate. Well, being a skeptical type, I naturally started looking for the hidden devils. And sure enough I found one.

What got me wondering was the fact that banks were taking deposits at 8-9%. So if they lent me at 8%, they would be incurring a loss. How would they even cover their fixed costs like salaries, rent, electricity, etc. Would a sensible looking bank deliberately make a loss? No, definitely not!!

Let's understand the gimmick employed here with an example.

Say we have a loan of Rs.2 lakhs @8% ‘flat’ interest rate, which is repayable in 2 years i.e. 24 monthly installments. [Notice the word "flat"? This is the devil].

At @8% flat interest rate, the total interest payable works out to Rs.32,000 as shown below:


    Total interest =  Loan amount * Interest Rate * No. of years
                      =  2,00,000 * 8% * 2
                      =  32,000
   
    Total repayment =  Loan amount + Interest
                           =  2,00,000 + 32,000
                           =  2,32,000

    No. of installments =  24 monthly payments

    Equated monthly installment =   Total payment / No. of installments
                                                =   2,32,000/24
                                                =   9,666.67 per month 

Simple? Yes.
Cheap? Well, not exactly.

So where’s the catch?

The catch is that you are paying EMI every month. A part of this amount is the interest portion and the balance is the principal portion. So month after month, as you keep paying the EMIs, your principal amount is reducing - till it finally becomes zero in the end. Technically one should pay interest only on the outstanding loan balance. But, as we have seen earlier, the interest has been calculated on flat basis i.e. on the ‘full loan amount’ for the ‘entire 2 years’.

In a ‘flat interest’ scenario you do not get the benefit of the reducing principal amount month after month. The result is that the effective interest cost to you works out to 14.68%. Yes, I repeat 14.68%.

So now it makes sense. They borrow at 8-9% and lend at 14-15%. But, we as a consumer, should beware of such so-called cheap flat interest rates.

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