It has
been long since Sanjay and Sanjana saw each other. Both were busy in their respective work
life. In addition to that Sanjay was
also studying for his professional course, which made it very difficult for him
to meet Sanjana. However, today being
his birthday, both of them decided to meet up for lunch and spend the day
together.
Sanjana
was already waiting at an Italian restaurant when Sanjay arrives in new clothes
looking smart. Sanjana was visibly happy
to see him after a long time. She hugged
him and gave birthday wishes.
“Gorgeous
birthday boy, thanks for meeting me on your birthday at least. Otherwise where
do you find time nowadays to meet me?”
as usual Sanjana started teasing him.
“Come-on
Sanjana, you know how much busy I am at work and studying for the exams due
next month. I hardly get time for any
other activities.” Sanjay started justifying himself.
Sanjana asked
looking at the menu, “So how are your studies going on for the exams?”
“Still
only half way through. I need to devote
more time on the studies for the remaining part of the month. And better I do, otherwise the examination
fees shall go in the drain so the loan I have taken.”
Sanjay started cribbing.
Not
understanding what Sanjay is saying, Sanjana asked “What’s the relation between
your exam and loan?” ordering pastas for both of them. As usual, she made a choice about what Sanjay
should also eat!
“Listen”,
Sanjay started explaining, “For the exams, I need to pay examination fees,
which were quite substantial and to pay that I took a loan on my credit card. So if I don’t do well in exams, my loan will
go waste.”
Sanjana
replied, “Well…irrespective of how much I educate you on money part, you still
waste your money. Taking a loan on your
credit card! How can you make such big mistake? Are you aware how much this loan cost you?”
“You
always take me for granted. Of course I
have learned about and implemented money management. Moreover, I have taken care of it while
taking this loan also.” Sanjay started
his firm defense.
“Is
it? Tell me what did you take care of
while taking the loan?”
“First,
as you had told me earlier, I made a list of various options I had to take a
loan. Then I compared their terms,
interest rates and ease of getting the loan.
Based on these criteria, the loan on credit card was the cheapest and
easily available.” replied Sanjay, visibly satisfied with his explanation.
Smelling
something fishy, Sanjana questioned, “How did you conclude that the loan on
credit card was the cheapest?”
“It’s
very simple. In fact, they are giving me
interest free loan. They are only
charging me processing fee of 5% on the loan amount and that’s all. I only need to repay the loan amount in equal
installments over 6 month’s period.
Since there is no interest, it is the cheapest of all”, replied Sanjay
brimming with smile.
Stunned
by the reply given, Sanjana yelled, “Credit card companies lure you
with interest free loans and you fall prey of such offers. Where did your learning of time value of money
go? Did you compare how much you are
paying to credit card company for the loan and at what point of time?”
Seeing
Sanjay a bit confused, Sanjana continued, “Listen. Let me explain to you. This all is gimmick of time value of money. They charge you ‘interest’ on the entire
amount in the name of processing fee and term it as interest free loan.
“Assume
that instead of processing fee, it is 5% interest on loan amount which needs to
be paid once at the time of disbursement of loan. What the credit card company has done is to
charge interest on the entire tenure of loan even though you are not using the full
loan for the entire tenure.”
“I am not
getting this.” confused, Sanjay replied, “Give me an example.”
“Look.”
Sanjana started explaining, “For example you took a loan of Rs. 50,000 from
your credit card company repayable in 6 equal installments of Rs. 8,333. Reducing processing fee of 5% from the principal
amount, net amount you receive is Rs. 47,500.
This you repay @ Rs. 8,333 in six equal installments. Simple IRR (internal rate of return)
calculations on your excel spreadsheet shall tell you that you have paid yearly
interest of more than 19% on this loan amount.
“This is so
since you paid the charges on the entire amount and not on the outstanding amount
post your installments every month.”
Visibly upset
by being again cheated Sanjay said, “I never thought of processing fees as
interest cost. I got lure by the claim
that the loan is interest free and there is only one time charge. But as you explained, time value of money is
of utmost importance which calculating interest cost.”
“Bang
on. Now you are on the correct
path. Compare what you are receiving and
paying along with the time periods and calculate the cost. It is very simple to determine by way of
excel spreadsheet. And you shall get the
interest cost on the loan you have taken.”
Sanjana added and continued,
“Now, don’t
get upset birthday boy. Let’s celebrate your
birthday today and take this lesson as a ‘valuable’ gift from me to you on
your birthday.” winked Sanjana.
