Lack of awareness among loan applicants, reluctance among non-banking finance companies (NBFCs) to be upfront about their products, and a certain laxity about disclosure norms by the sector regulator have meant that customers end up paying much higher interest on loans than they should, according to industry players.
Reducing balance loan
A frequent occurrence is when NBFCs don’t convey to the borrower that a reducing balance loan works out cheaper than a fixed-rate loan, even though the latter ostensibly starts at a lower interest rate.
“There are two types of interest rate schemes in personal loans,” said Aditya Kumar, founder and CEO of Qbera, a Bengaluru-based digital lending start-up.
“The first is a reducing balance interest and the other is a flat rate of interest. Reducing balance means that every month, as you repay the principal, the interest rate that has been quoted to you will only be charged on the balance of the loan, not on the initial loan amount. The flat rate of interest, charges you interest through the life of the loan on the initially agreed loan amount.”
So, for example, for a ₹1 lakh loan for 36 months, a flat rate of 10% will mean the borrower pays a total interest amount of ₹30,000.
On a reducing balance loan of 15%, the borrower ends up paying only ₹24,795 of interest.
“A customer, however, will immediately choose the 10% flat rate loan because of the lower interest rate,” Bala Parthasarathy, co-founder and CEO, MoneyTap, an app-based credit line, said. “The details are in the fine print, which nobody tends to read.”
The reason for this, Mr. Kumar explained, is partially that consumers do not know the difference between flat rates and reducing balance rates.
The regulator does not require the lenders to disclose the facts fairly, either.
“What people are trying to do is to actually disguise flat rate loans as reducing balance loans,” he added.
“Some lenders are saying they are giving a personal loan at 9.99%. They don’t say whether this is a flat rate or reducing balance. As of today, they are not obligated by the RBI to disclose what the effective interest on a reducing balance basis would be,” Mr. Kumar noted.
“It’s a combination of consumers being misled, the lenders not being transparent, and the regulator not putting the onus on the lenders to make appropriate disclosures.” “In the U.S., for example, there is something called ‘truth in lending’, and they have similar Acts elsewhere in the world that govern fair practices and mandatory disclosures.”
“Unfortunately, it’s a very prevalent trend in the industry,” Mr. Parthasarathy added. “The banks typically don’t do it, but the NBFCs tend to do it. And this is a big problem, because the NBFCs cater to that segment of the population that is not too educated about financial matters,” he added.
