Loan? Have you considered loan against Fixed Deposits (FD)?

Even though this is a very long article, please do read it and rate it ...

First a clarification. This article is not for Home Loan and certainly not for the business person. And in later sections I shall explain why. OK. To topic ...

• Have you ever wanted a quick loan to tide over some important situation (will not call it crisis)?
• Do you wish to own that fantastic backlit LED LCD TV or a new car?
• Are you going in for personal loan at 14-16% interest or worse still a credit card loan at 36%?
• Do you know that there are other sources of loan such as loan against property, loan against jwellery, loan against shares/MF's?

If the answer to first three questions is a "Yes" and the last one is "No", then let me shed some thoughts on the last point.

Very often we go in for a personal loan at high interest rate. Especially when going in for a car/two-wheeler, one will opt for the finance at the spot from the bank/finance companies. I am especially concentrating on vehicle loans in this article but this applies to other categories (except home loan).

Note that two wheeler loans are rarely offered at a discount especially on the hot selling bike.

Even though the rates look ridiculously low, they aren't really so. The typical vehicle loan is 11% ± 1%. So when you walk in to the nearest car showroom, the guy tells you that he will offer you the loan at 8%. How is this possible? This is because the manufacturer and the dealer come up with a discount scheme that is not transparent to you. Here let me explain:

a) The bank offers the loan at 11%. So if you are going for a loan of Rs. 750,000, your EMI is Rs. 16,159 for 60 months.
b) The manufacturer and the dealer come with a finance discount scheme wherein they will offer a finance payout of, say, Rs. 63,000 to the bank.
c) This amount is directly adjusted from the EMI payout (Rs. 63,000 / 60 is deducted from your EMI of 16519. This now becomes Rs. 15,109.
d) The new EMI now means that that your effective rate is 8.01%.

There seems to be nothing wrong with the above discount, right? After all, a discount is a discount - one way or other. One cannot be more wrong.

a) Now just suppose, you were offered this as a cash discount. This means that instead of seeking a loan of 750,000, you will now need Rs. 687,000. This results of an EMI of Rs. 14,801.37 at 11%!!!!
b) If you decide to not finance the car and purchase it outright, the manufacturer/dealer does not offer you this discount.

Unfortunately, there is nothing we can do about it. The car loan (or any loan) is still very costly, inspite of the above discount. Your total interest payment over 60 months is Rs. 156,540. There are several other disadvantages:

• You cannot foreclose the loan before first six months.
• Even if you wish to foreclose, there are penanlty charges such as two EMIs or 5% of balance amount, etc.
• Vehicle needs to be hopothecated.
• You will need to pay admin fees, processing fees, stamp duty, etc. on the loan. This could easily add to Rs. 6K or above.
• You cannot sell your car till your loan is paid off and hypothecation cleared.

There are others too but let us leave those arguments for the time being. There is a solution. You can avail secured loans such as loan against FD, jwellery, shares/MF, property, etc. Out of all of the above, loan against FD has the least hassles:

• Jwellery has to be certified by a registered valuer. Bank will give 85% loan against the valuation. Rate is the standard commercial rate.
• Same holds true for property, shares, MF's, etc. For these, there is a lot of paperwork involved.
• Our psyche is such that we are not too keen to hypothecate jwellery and property for loans - blame it on bollywood if you will.

But loan against FD is complete hassle free. Since the FD's are already held by the bank, all you have to do is hypothecate (secure) them against the loan. Banks will charge an interest of 1.5% to 2% more than the FD rate. The FD is held as a security but will continue to earn interest as usual. Paperwork will take no more than 2/3 days. Bank will transfer the loaned amount to your account within a day after that.

The advantage of such a loan is that you can repay as much as you want/can, any time as you want. Interest is calculated on the daily reducing balance. You could even request the bank to adjust the interest payable on the FD against the loan pricipal outstanding.

But be aware of the following:

a) The tenure must be a minimum of one year.
b) You must have the fiscal discipline of repaying every month just like you do with the EMI.

Consider the following example/assumptions:

a) You have FDs worth Rs. 800,000 with a bank at 6%. You take a loan of Rs. 750,000 at 8%.
b) You pledge interest payable on FD to loan payment. Because of this your FD amount remains at 800K and they will earn an interest of Rs. 48,000 in the every year till loan is paid off.
c) You make it a point to repay Rs. 15,000 every month just like the normal loan.
d) Every year, at your job, you get the annual bonus/performance incentive payment of Rs. 100,000 (post tax) which you use as a prepayment.

If you use the above logic/formulae, you will find that you will have repaid the loan in 37 months. Now brace yourself:

the interest paid in these 37 months against such a loan is Rs. 95,331. This is a saving of Rs. 61,209. This is over and above the Rs. 63,000 discount offered on finance.

(to be continued ...)

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Questions to ponder upon:

a) Why does this not apply to Home Loans?
b) What is wrong with a business man going for such a loan?
c) If you have the money in FD, why not break the damn FD and buy the car outright?

Excellent article. Most people do not pay attention to these details and in the long run end up paying lots of money where they didint really need to.

Fixed deposit in a bank is something I have a different opinion about. FD in a bank brings in interest income which is taxable and even if some one falls in a lower tax bracket the amount of tax you pay on it takes away a big portion of the money you make out of it and whatever is left is not enough to beat the inflationary effect over time given the inflation rate in India for the last 10 years and things wont get any better in the near future either... So you basically loose the purchasing power of that money actually keeps on decreasing over time post taxes.
Equity on the other hand is tax free if you stay invested for more then a year and also the dividend is tax free... The returns from a good Mutual fund or carefully selected portfolio will beat inflation without a doubt and the returns will be considerably higher as compared to a bank fixed deposit. The only exception being senior citizens who cannot risk their capital or wait for very long durations to reap good rewards from stocks... for them an FD is a much better risk free investment.

Loan against gold is a very good idea even though gold prices have shot through the roof recently there is still a lot of headroom...

Why is a personal loan costlier then say loan against stocks/MF or Gold?

Simply because a personal loan is an unsecured loan and the other is secured against stocks/MF or gold and risk for the bank in lending money to you decreases and they can afford to provide a loan at a lot lower rate then they would for an unsecured loan.

Home loans are already secured loans and the rate of interests are amongst the lowest for a home loan.

As Just4kix already said discipline is the key. More disciplined you are in financial matters .. more successful you will be in times to come

I left some questions open:

a) Why does this not apply to Home Loans?
b) What is wrong with a business man going for such a loan?
c) If you have the money in FD, why not break the damn FD and buy the car outright?

Admin has already answered some of them either partially or in full.

Home Loan
The Home Loan is one of the cheapest loans available in the country. On top of that, there are benefits available in the personal Income Tax. The principal amount repaid can be set off under section 80. As we all know, a sum of Rs. 1,00,000 can be available as rebate under section 80. If the loan is for a house for self occupation, an amount up to Rs. 1,50,000 or the interest repaid (whichever is lower) can be claimed as a rebate under section 24. Hence there is no point taking loan against FD for buying or refurbishing your home.

Business scenario
A business man can claim interest paid on loans as a business expense. Further he can also claim depreciation of the car to set off against the gross profit. As per company laws, the vehicle asset can depreciate up to 33%. The net profit after the above deductions will now be subject to tax. If this results with a notional loss, it can be carried forward to the next year.

Hence there is no point in having a low interest loan. The money is better served by reinvesting into business. But there is no harm either if the business man also opts for loan against FD.

Why not buy the car outright?
There is a definite YES here. But again the watch word is "fiscal discipline". If you break FDs and buy a car (a depreciating asset), you have just blown away your liquidity. If you can pledge yourself that you will regain the same amount by saving/reinvesting in the same period as the loan, then definitely go for outright purchase. But less than 1% of the people follow a fiscal discipline. So, if you are unsure about yourself, go for loan against FD. After you have repaid the loan, you have got back your liquidity.

p/s. This article is a result of my own study and deep analysis using MS-Excel as the tool. If someone likes to have a solid proof, I can share the XLS.

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Update/Edit: I called SBI and they told me that they charge interest at 1% more than the FD rate.

Hi just4kix,

Excellent article and I hope this will help a lot of people for sure. I was actually searching for some details on loan against FD and this has helped me a lot. Though the article is almost one and half years old, I would request you to share the XLS so that it helps a lot of people.
Request you to share the XLS in the forum.

nice article, its very knowledgeable and helpful for most of the guys