The Supreme Court has suggested that lenders charge simple interest during the six-month moratorium period declared by the RBI, instead of levying compound interest (interest on interest). Banks and other lenders have been permitted by the RBI to allow borrowers to delay the payment of instalments due between March 2020 and August 2020. However it has been made clear that interest will continue to accrue during this period plus there will be interest on such interest accruals (compound interest) as well. Some borrowers have argued that this is no relief at all and that the interest during the moratorium period (March 2020 to August 2020) should also be waived or at least only simple interest should be charged during this period.
Understanding the payout
To understand this, lets take the example of a home loan of Rs 50,00,000 outstanding as on February 1, 2020 at an interest rate of 8 per cent p.a., where 180 monthly instalments of Rs 47,800 approximately are payable till February 1, 2035. The borrowers who argue that interest-free moratorium should be provided want to start paying the first instalment only in September 2020 and the last instalment in August 2035, thus getting an interest- free six-month period.
Banks on the other hand claim that it is a cash flow facility being given to the borrowers and compound interest will continue to accrue for the moratorium period as well. For the given example the interest for this six-month period amounts to Rs. 2,03,000 approximately, which gets added to the principal. Therefore, instead of 180 instalments of Rs. 47,800 starting from September 2020 (and ending on August 2035) the number of instalments increase to 194 and the loan repayments will now end in October 2036 instead of August 2035 earlier. In fact the simple interest during the moratorium period is Rs. 2,00,000 (instead of compound interest of 2,03,000) and the number of instalments remain at 194 with only a rounding off difference between the 2 figures.
The lenders justifiably argue that it is not possible for them to provide an interest-free period to borrowers since they pay interest to their depositors for the same period. Besides the prohibitive cost of providing such an interest waiver, it has been reportedly pointed out by SBI that more than 90 per cent of the borrowers have not availed of the moratorium offer and thus there is the issue of “moral hazard.” This means that those who do pay their instalments on time and do not avail the moratorium feel like fools for having done the right thing. There seems to be much less justification for not following simple interest during the moratorium period since it makes very little difference in the end even for shorter tenure loans.
A win-win proposal would be offering a prompt payment discount to all borrowers who pay all their instalments on time after availing the moratorium facility. The prompt payment discount is given at the end of the tenure if all instalments are paid in time from September 2020 onwards. In the given example, if lenders give a 1 per cent p.a. ‘prompt payment’ discount, the number of instalments left for payment after September 2020 will be just 173, which means all payments will be made by January 2035, even earlier than February 2035 as contracted earlier without the moratorium. Effectively, the borrower can enjoy the six-month moratorium till August 2020 and as long as he pays the balance 173 instalments on time the loan will be treated as fully paid in January 2035 itself, rather than the original contracted February 2035.
Compounding interest
The magic is because of the power of compounding over the long balance period of the loan. This has several advantages for lenders as well. There will be a strong incentive for borrowers so as to pay on time to avail the benefit of the prompt payment discount and the lender will more than make up for the discount by way of much lower NPA write offs. It will promote a strong culture of payment on time, which can only be good for the economy as a whole. Borrowers who do not opt for the moratorium can be rewarded more and thus allowed to end their loan even earlier than those who take the moratorium. Also, since the benefit is available only in the end, a bank will be able to keep its well-paying borrowers with itself and will not lose them to other lenders or due to prepayment, as in that case borrowers will lose the benefit of the prompt payment discount. If the regulator allows for the prompt payment discount to be accounted in the lenders books towards the end, it will also buttress lenders’ bottom line at a time when it is under severe stress. All this will, of course, work much better for longer tenure loans but it would provide some benefits even for shorter period loans.
Of course, it will only work if RBI enforces it as a regulation.
(CA Harsh Roongta is a Fee only Investment Adviser and a well know personal finance and tax expert. He can be reached at www.harshroongta.com)
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