Upfront instalments in a personal loan the real cost

The stated rate of interest is not the actual rate that a person pays on a personal loan in all cases. The manner of calculation of the rate and the base on which this is done play an important role in determining the final cost. A higher rate is charged when a completely different base than what the actual loan is for is considered for calculation.

The loan has to be repaid in several installments that will depend upon the conditions fixed at the time of the allotment of the loan. This will mean that the repayment of the loan is specified. But what is often not mentioned clearly is that several installments will actually be recovered from the person at the time of loan disbursal itself.

There are two consequences of the entire move. The first which many people actually figure out and are comfortable with is the amount of funds that they need to raise on their own. Consider a case where a person takes a loan of say Rs. 1 lakh and this has to be repaid in the installments of Rs. 5,100 in 24 months. If the lending institution asks for 2 installments to be put up at the start of the loan itself then Rs. 10,200 has to be put upfront. Most people consider this to be an acceptable point while taking a loan because they consider this as a down payment that is a part of their responsibility towards the loan. They consider that they just got under Rs. 90,000 as the loan and the remaining amount is what they are financing for the entire purchase. This way of looking at the entire matter enables them to understand the position as far as the cash flow structuring is concerned.

The point that most people either miss or do not understand is the actual interest working on the entire loan. It is not very technical to ask an individual to put some money upfront before financing the remaining amount. Here, it is considered as if the person has been given a loan for the entire amount and then he/she is paying back this amount by making some installment payments in advance. The real impact takes place on the calculation of interest.

Since it is considered that the loan is given for the entire amount the calculation of interest also takes place on a larger base. This is actually a blow for loan borrowers because they are actually not enjoying the benefit of this extra amount as they are repaying the same immediately. In that sense it becomes an amount on which a person pays interest for nothing. This is the reason why the overall interest rate becomes high for the borrower when the stated rate actually does not look too threatening. This is the way in which many people unsuspectingly end up paying a higher amount of interest.

Consider this example:

Gaurav approached a private bank for a personal loan of Rs. 1 lakh for 1 year. The bank said that it would provide him the loan at an interest rate of 16% p.a. and the EMI would be Rs. 9,073. A condition was that Gaurav would have to pay 2 EMIs (i.e., Rs. 18,146) in advance. In effect, this meant that he would receive a loan of Rs. 81,854 on which he would have to pay 10 EMIs of Rs. 9,073. The real interest charge for this loan now comes out to 23%.

As you can see, upfront installments often prove to be more expensive even if interest rate on them might be lower.