Girish Ganaraj
Over the last three months, many have faced salary cuts, job losses and seen the health and lives of near and dear ones being traumatised. And for most, this is a first-time experience.
In support, the salaried middle-income person has also been given some concessions. An extended six-month “moratorium” on their loans taken from banks/NBFCs has been allowed. All kinds of loans, including credit card debt have been included in the moratorium.
The terms of the moratorium are simple – your EMI is only deferred, not waived. There is no interest waiver. Non-payment (i.e., deferral) does not impact your credit score.
Hence, it is advisable to pay your EMIs, and not take the moratorium, unless you face dire circumstances, because of which you are unable to pay. And if you do, pay back the deferred EMIs as soon as possible, to minimize the long-term impact.
But why so? The reason is simple. Taking a six-month moratorium on a home loan that has 15 years left adds another 18 EMIs! And this is because of the effect of compounding over long periods of time.
What is the impact?
So, the calculations are simple. I have tried to explain the impact for a home loan in a simple way below.
Loan Amount (Principal) outstanding – Rs 50 L
Years of Loan outstanding – 15 years (180 months)
Rate of Interest – 9% (monthly reducing)
EMI – Rs 50,713
Now, let us assume that you take a six-month moratorium, i.e., don’t pay the EMIs for the next six months and re-start paying from month seven. What happens?
IMPACT 1
-Your principal outstanding of Rs 50L accumulates interest at the rate of 9 per cent, and hence interest accumulated over the next six months (calculated using Simple Interest formula – 50L * 9% * 6/12) is Rs 2,25,000.
-Therefore, the loan outstanding at the beginning of month seven, when you re-start repaying the loan is Rs 52.25L, not Rs 50L, which it was six months earlier.
Of course, this is easy to understand. But still, it’s only Rs 2.25L, less than 5 per cent of the loan amount. How much can it really impact my overall loan repayment plan?
Now, here is where compounding becomes your enemy.
IMPACT 2
-In effect, you are paying off two loans, one of Rs 50L, and the second one of Rs 2.25L.
-Now, with the same EMI (most likely), the original loan outstanding of Rs 50L will take 15 years (i.e., 180 months) to be paid off, as per the original plan.
-Unfortunately, during this time, the Rs 2.25L “loan” continues to remain unpaid (i.e., like a 180-month moratorium), and compounds at 9 per cent annually to Rs 8,63,560, up nearly four times.
-You then start repaying this second loan, at the beginning of the 16th year, and with the same EMI, clearing this loan will now take about 18 months.
- So, simply put, if you take a six-month moratorium (i.e., deferral of six EMIs totalling to a little more Rs. 3.04L on this home loan), and repay at the same EMI, you end up paying 18 more EMIs, about Rs 9.27L.
This impact gets magnified, as the outstanding tenure or interest rate goes up. A 20-year outstanding tenure (i.e., 240 months) increases the number of extra EMIs to 34! And a 1 per cent point higher interest rate (i.e., 10 per cent) increases the number of outstanding EMIs to 23.
Is the impact similar for shorter-tenure loans too?
The effect of compounding magnifies the effect over longer tenures and at higher interest rates, and is lower, at lower tenures and rates.
-So, in the home loan example, assume that you had only five years of EMIs left, and your EMI was the same, you would end up paying less than four extra instalments!
-And instead of a home loan, if you have a vehicle loan for five years at 14 per cent, you would pay about six extra EMIs, due to the higher interest rate. Similarly, for a personal loan for three years at 16 per cent, you would pay about four more EMIs.
Lessons for borrowers
Moratorium-specific
-The moratorium is only a deferral of EMIs without impacting your credit-worthiness, not a waiver of interest. The cost of this deferral is quite high, as explained above. Hence, if you can, it is better to keep paying the EMIs and not take the moratorium.
-In case you don’t have the cash-flows and have to take the moratorium, pay back the accumulated interest quickly, rather than let it compound over the loan duration. If you cannot do that, increase your EMI so that the tenure does not get extended. In our example, increasing your EMI at the end of the moratorium by less than 5 per cent – Rs 52,995 (from Rs 50,713) – completely eliminates the extra EMIs!
-The impact in terms of number of additional EMIs is higher over longer tenures, and higher at higher interest rates. Hence, even for short-term loans where interest rates are high (e.g., revolving debt on credit cards), the impact can be quite significant.
In general, for all loans
-Compounding is said to be the eighth wonder of the world. But it is a wonder only when it works for you, i.e., for your long-term investments. When it comes to loans, it works against you!
-The impact of higher tenures works significantly against you, since the EMI drop is marginal compared to the higher tenures. For our same Rs 50L home loan example:
-EMI for a 15-year loan: Rs 50,713
-EMI for a 20-year loan: Rs 44,986 (33 per cent more months, only 11 per cent lower EMIs)
-EMI for a 25-year loan: Rs 41,960 (25 per cent more months, only 7 per cent lower EMIs)
Hence, if ever you take a loan, remember: stretching yourself means increasing the EMI over a shorter tenure, not extending the tenure longer.
-It is also important for you to continuously follow up with your bank and seek interest-rate revisions on your home loan, especially when there are rate reductions. These do not necessarily happen automatically, and every month you delay this, you are making compounding work against you.
-Lastly, use loans as a lever to make your overall finances work better for you. Loans are good when you know that you can afford whatever it is that you are funding, and when the rest of your savings are working better than the rate at which you are taking the loan. Remember, taking a loan is nothing but borrowing from your future earnings, hence make sure you are not putting your future financial security in danger by having a more luxurious present.
(The writer is a financial planner and NISM-certified investment advisor, and co-founder of Finwise Personal Finance Solutions)
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