Most of us have either taken a loan sometime in the past or will be required to take one to fund our car,home, education ,personal needs etc. As a prudent borrower we all look to get the loan at the best possible rate. We all want best deal from the bank. But do you know what exactly constitutes the best deal for you? Is it the rate of interest charged on your loan? or is the mode of interest charged i.e. fixed or floating? Or is it tenure of the loan? or is it something else?
When a person takes a loan, he will most certainly look at the rate of interest charged to him on the loan . He wants a loan at the lowest possible rate of interest. This is not entirely wrong as lower the rate of interest, chances are that the deal would keep on getting better. Now , here I said "chances are" because lower rates do not necessarily mean a better deal or a cheaper loan.
How is that possible? To find out the best possible deal on your loan, you should look at the IRR (Internal Rate Of Return or effective rate of return) on your loan and not the stated rate of interest. IRR gives you the correct sense of the interest you pay on your loan. There are various other parameters in a loan which determine your actual outflow of interest .
1. Advance EMI - Advance EMIs for instance will reduce your stated interest rate but increase the IRR i.e. while it may look like a cheaper loan to you because of the lower stated rate of interest on account of paying upfront advance EMIs, you would end up paying more. When a bank takes advance EMI upfront from you, they are actually giving a loan of lesser amount ( Loan sanctioned - Advance EMI= Loan Given to you). While they give you loan of lesser value they still charge you interest on the original sanctioned amount, which increases your total outflow. Banks use this strategy very effectively to deal with customers who only look at the stated rate of interest before deciding on the loan. This strategy is also widely used in the famous "0% interest loan" for consumer durables. As a prudent customer we must understand that there is no free lunch and the 0% interest loan actually works on the principal of taking 4-5 advance EMIs upfront along with some processing fee. This helps them jack up the IRR on the loan while keeping the stated rate of interest 0. The customer is happy thinking he got a 0% loan and bank is happy because it knows it is getting its share of interest income.
2. Processing Fee - Another important factor that one needs to look at while deciding on any loan is the processing fee part. Most of the banks charge processing or admin fee to the tune of anywhere between 1% to 4% of the total loan sanctioned. The processing fee of 2-3% on home loan works out to be a decent amount. Customers tend to look at this as one time expense and do not consider this as part of the outflow. Banks at times will give a 50 basis point discount or waiver on the interest rate but might increase processing fee to make up for the revenue loss. The customer thinks he got a better deal , but sadly that is not true. Processing fee is very similar to advance EMI as here too the borrower pays an amount upfront from his loan sanctioned and his loan amount gets reduced to that extent. The bank however, will still charge him interest on the original loan sanctioned.
3. Tenure - This is another parameter which decides the overall interest fee outflow that you will have on your loan. A shorter tenure is always better for a borrower since it minimises the interest component in your loan repayment , while a longer tenure will mean you will pay more interest on your loan. Banks use tenure too to play on the mindset of the customer to have a loan with lower interest rate. They will reduce the stated rate of interest but will increase the tenure. This will most probably do more damage to you than benefit you. You need to do your IRR calculation to know the exact scenario.
Simple way of calculating the interest Outflow - Well the best and most accurate way of knowing your actual rate of interest is to find out the IRR on your loan in Microsoft excel or from a scientific calculator. But for people who want some quick bank of the envelope calculations on this, they may consider this
Your loan EMI * Tenure = Total Money paid to the bank
Total money paid to the bank - Loan amount received in hand = Total interest paid
((Total interest paid/Loan amount received in hand)/tenure) *100= flat interest rate ( this is not same as reducing rate of interest)
But, I would suggest you find out the IRR of the loan as it gives the exact picture of the effective interest that you are charged on your loan.
How should you negotiate ? Now , you know that there are 3 elements which impact your IRR or effective rate of interest ( not counting the mode of interest charged that is reducing or fixed, always opt for reducing rate on interest), you must negotiate with the bank to get any one of the 3 elements down or lower while keeping the other 2 constant. Best would be to get all 3 elements down from the banks original offer.
Banks do have some scope to offer discounts on their original rate and hence you must negotiate hard with them.