Friday, June 26, 2009


While deciding on the home loan ,personal loan or car loan we are all very sensitive to the rate of interest being charged on the loan by the bank. This is because rate of interest directly impacts the repayment amount of the loan. A higher rate of interest obviously means more interest payout and hence is that much less desirable. This is perfect. But, what most of the loan seekers do not focus on is the tenure of the loan. Tenure of the loan , like rate of interest, impacts the repayment amount directly. Tenure is very important factor that one needs to check and negotiate on while taking a loan. Let us understand in greater detail how tenure of the loan impacts us.

1. Longer Tenure Increases the repayment amount on the loan - Let us consider an example. Assume Mr. X takes a personal loan of Rs 100000 at an interest of 10% annually for a period of 3 years. Consider the rate of interest as flat for sake of simplicity and ease of understanding. Now, for a tenure of 3 years the total amount that Mr.X will have to repay would be

Rs 130000. The monthly EMI would be Rs 3612. Now, If Mr. X wants to repay the same loan in 5 years, his terms are likely to change. For longer tenure loan , the banks charge a slightly lower rate of interest. So lets assume his rate of interest for a 5 year loan of Rs 100000 is 9%. Then his total loan repayment amount would be Rs 145000. The EMi would be Rs 2416. Thus, you can see that for the same loan Mr. X would end up paying Rs 15000 (145000-130000) extra if the tenure is increased from 3 years to 5 years.

2. Longer Tenure reduces the rate of interest and EMI amount - In the above example, you saw that both the rate of interest and the EMI amount for Mr. X was reduced from 10% and 3612 to 9% and 2416 respectively. Thus longer tenures makes the loan EMI more affordable for a borrower. This is the benefit of loans with longer tenure. Loans with high sanction amount generally are of longer tenure to make the EMI affordable to the borrower. Example is housing loans where most of the loans are of upto 20-25 years tenure. But, the point to note is that even though , increase in tenure reduces the nominal rate of interest charged and makes the EMI more affordable, the overall interest component and the loan amount to be repaid is increased.

There are times when longer tenure makes sense while there are times when shorter tenure makes sense.

Longer Tenure Loans

1. In case of loans where the loan sanction amount is high ,like in case of housing loans , the EMI would be very high if the tenure is short. To make the EMI affordable , one must increase the tenure of the loan.

2. As a corollary to the above point, a longer tenure in the loan, increases the loan eligibility of the borrower. This is because of the fact that loan eligibility of a borrower is based on,among other factors, the EMI that he can afford. A lower EMI does increase his loan eligibility.

3. The value of money decreases over a period of time i.e. the purchasing power of rupee decreases over a period of time. In a potentially inflationary economy, longer term loans might make more sense as the depreciation in the value of the rupee would be more and in effect the money that you would be repaying would be lesser in real terms. But, it is very difficult to judge the inflation rate 10-15 years from now on.

4. Longer tenure loan can really hurt if you are looking to foreclose the loan in short time, since in loans with longer tenure, the first few EMIs , more or less goes towards interest servicing and as such when you foreclose the loan ,the loan amount would hardly reduced and you will have to pay the entire the loan amount along with the foreclosure fee.

Shorter Tenure Loans

1. Shorter tenure loans makes sense for people who can afford relatively higher EMI. Shorter tenure makes your loan cheaper since the interest component on the loan is lesser.

2. Suited best for people looking to foreclose or pay off the loan quickly.

3. Does not require long term commitment and as such is less of a strain on your future cash flow.

Hence, you can see that both have their own advantages and disadvantages and you must decide between them depending on your need.

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