BQ Explains: How The Government’s Compound Interest Waiver Affects Your Loans, Credit Cards

The Indian government released details of its scheme to offer relief to individuals and small businesses with outstanding loans of up to Rs 2 crore last week, with the RBI operationalising it on Tuesday. Lenders have a short window until Nov. 5, 2020 to compensate borrowers for the compound interest that may have accrued over a six-month period starting March.

According to the scheme, borrowers in loan categories including MSME loans and a variety of retail loans, that availed of the Reserve Bank of India’s moratorium on loan repayments, will not have to pay the compound interest or the interest-on-interest that banks were accruing over the six months of the moratorium.

Those borrowers that had continued repaying their loans as per schedule will also stand to benefit. For such borrowers, it will be assumed that they had availed of the moratorium, and the compound interest that would have accrued will be adjusted against their outstanding loans.

How can consumers compute the amount due to them to ensure banks compensate them adequately? BQ explains...

Illustration 1:

Home loan of Rs 10 lakh at a fixed rate of 8%, to be repaid over 10 years.

For the purposes of this illustration, we have assumed that the individual’s first repayment was to happen on March 5.

• Having availed of the moratorium, the individual does not make the EMI payment of Rs 12,133, which includes a principal component of Rs 5,466 and an interest component of Rs 6,667.
• The interest component, as a result, gets added to the outstanding principal, which as on April 5 stood at Rs 10,06,667. The interest payable in that month is then calculated using this higher principal.
• In a similar manner, the interest payable every month continues to be added to the outstanding principal, which at the end of the moratorium adds up to Rs 10,33,781.
• This includes accumulated simple interest of Rs 40,002 and interest-on-interest of Rs 671. According to the government’s scheme, this interest-on-interest will be waived.

Starting September, the borrower will have two options — either the EMI is adjusted higher, to reflect the increase in the principal outstanding, or the tenor of the loan is extended by six months.

“The benefits would naturally be higher for those with higher loan outstanding, who had not availed of the moratorium,” said Arvind Rao, certified financial planner and founder, Arvind Rao & Associates. “Also, those at the early stage of their loan repayment cycle will benefit more than those that have nearly completed their loan repayment.”

Banks generally structure loan EMIs to have a higher amount of interest in the first half of the repayment cycle. Towards the end of the cycle, the EMI is comprised almost entirely of the principal.

Explaining the likely thinking behind the decision to include borrowers who did not avail of the moratorium in the scheme, Amol Joshi, founder of PlanRupee Investment Services said, “There is no compounding as such if I have paid all the loan instalments, but the government is making good the cost of money incurred by me for making the scheduled payment.”

Illustration 2:

Home loan of Rs 10 lakh at a floating rate of 8%, to be repaid over 10 years.

This illustration is, essentially, a subset of the first one. Let’s assume that the interest rate on the home loan was 8% at the start of the moratorium. Subsequently, because of changes in the policy repo rate by the RBI, the home loan rate fell to 7.5%.

However, as per the notification from the Finance Ministry, the calculation would not include changes in the interest rate during the six months of the moratorium. So, for the purposes of the calculation, the interest rate would remain 8%. The benefit to individuals will, as a result, continue to be Rs 671 in this scenario.

At the end of the moratorium, once EMI payments restart, the prevailing interest rate will apply.

Illustration 3:

Credit card dues are also included in the government’s scheme. However, the rate of interest used to calculate the interest-on-interest in the case of such dues will not be the rolling over interest rate that is normally levied.

In its notification, the Finance Ministry clarified that for credit card dues, “The rate of interest will be the Weighted Average Lending Rate charged by the card issuer for transactions financed on EMI basis from its customers during the period of March 1 to Aug. 31.”

CS Setty, managing director at India’s largest lender State Bank of India, said the differential in the simple and compound interest on credit card dues will be calculated assuming that the borrower’s dues have been converted to an EMI at an annual interest rate of 18-20%.

• Let’s assume, then, that an individual had an amount outstanding of Rs 1 lakh on their credit card as on Feb. 29. At an annual rate of 20%, the simple interest on this outstanding would amount to Rs 1,667.
• If the interest were to be compounded, it would lead to an additional charge of Rs 424 over the course of the next six months.
• A user of a credit card that availed of the moratorium would have an outstanding of just over Rs 1.08 lakh at the end of August. For this individual, the additional charge of Rs 424 would be waived.
• An individual who had credit card dues of Rs 1 lakh as on Feb. 29, but who did not avail of the moratorium, would receive a benefit of Rs 424 under the government’s scheme.