Misconceptions over Low Interest Personal Loan
A friend of mine received a call from a banker last week, offering him a low interest personal loan of RM 34,000 at 5.99% per year, with 5 years repayment terms. The idea put forth to him was that he could use this RM 34,000 to repay part of his current RM 200,000 home loan, which had a 20 year tenure, which ultimately should help in saving his home loan interest. The reasoning was that the RM 34k if settled with the personal loan, would save substantial interests if it were continued to be paid over 20 years.
With his current home loan interest of 6.5% p.a., he was quite moved by the offer, as from the initial sound of it, the personal loan of 5.99% might very well help to reduce the interest expenses by 0.59% p.a. for the next 5 years.
Is that so?
He came to me for an advice and I told him that he would not be saving any interest, but in fact would be paying much higher interest than he thought!!!
First of all, it is vital to understand the two major distinctions, in term of interest rate calculation, between a home loan and a personal loan.
Home loan interest is calculated based on monthly reducing balance basis, which means you are charged only on the outstanding amount.
Personal loan in Malaysia, however, is based on a flat interest rate. This means you are charged interest on the original principal amount, no matter how much you have paid off. Consequently the effective interest rate is considerably higher than the normal flat rate initially quoted. Hire Purchase loan is one of the common flat rate loans in the market.
So, in terms of effective interest rate we are paying, in simple terms: –
1. An interest rate quoted based on a monthly reducing balance basis, has an effective interest rate which is equal to the interest rate quoted itself, (since it is based on reducing amount of the principal).
2. Flat rate interest, though often appearing cheaper, has in fact a much higher effective interest rate than it appears. The general rough rule of thumb in calculating the effective interest rate for a flat rate interest would be to multiply the interest rate of a flat rate loan by 2!!
Hence, a 5.99% personal loan would roughly equal to a monthly reducing balance interest rate of 12%, which is about double the home loan interest he is currently paying.
To begin with, we have to dispel the notion that paying off RM34k portion of the term loan now using the personal loan would save the interest of paying it over 20 years. This would be true if not for the fact that if he took the personal loan, he would be paying a higher monthly instalment amount during the 5 year personal loan period – hence to compare apple to apple, he should then re-compute the interest costs under the term loan by assuming he now starts paying the same higher monthly instalment amount as under the 5-yr personal loan, to settle the term loan instead.
I have done a simple calculation to illustrate to him the total interest that he would have to pay on this RM 34k based on flat rate loan (5.99%). Subsequently, we did a model assuming he paid the same monthly instalment amount that he would under this flat rate loan and applied this to the reducing balance term loan, what would be the amount of interest rate he would have paid under a monthly reducing balance home loan (6.5%):
1. Flat rate loan
Principal = RM 34,000
Interest rate: 5.99%
Tenure: 5 years
Total interest payable for 5 years: RM 10,183 (RM34k X 5.99% X 5 years)
Total repayment per month: RM 736. 38
2. Monthly reducing balance loan
Principal: RM 34,000
Interest rate: 6.5%
Total repayment per month: RM 736.38 (above flat loan mthly instalment)
Tenure: 4.5 years (*)
Total interest he will pay: RM 4,989.74
(*) – i.e. if paying the same mthly instalment amount under the personal loan will result in a shorter repayment period under a reducing basis loan.
From the above example, we can see that he needs to pay extra RM 5,193.26 interest if he opts to take up the personal loan (double what he would have paid under the monthly reducing balance loan). Ultimately, this has a huge impact on the cost of the loan. Also, the repayment period under the reducing basis would be 4.5 yrs instead of 5 yrs under the personal loan.
So, don’t get too excited when a banker offers you a personal loan with interest rate which appears cheaper than you current home loan. It will make no financial sense if the offer interest rate is not more than half the interest rate that you are currently paying. As for my friend case, unless the banker is offering him a personal loan with interest of less than 3.25% p.a. (6.5%/2), he should not take up the offer.