How can a 6.6% FD Outperform a 12% Private Mortgage – Arithmetic Behing The Stunning Fact

Question: Ought to I Use an FD to finance the acquisition of my iPhone Professional Max 1TB?

Suppose I would like to purchase this telephone which is able to price me about Rs. 2,00,000. I’ve this a lot cash as money in my checking account.

However I need to put this cash in FD which is able to fetch me about 6.6% return (for five Years). Based mostly on this residue, let’s say I get an individual mortgage (with 100% financing). Which implies, for a Rs. 2 Lakh deposit, I’ll get a Rs. 2 Lakh mortgage for 5 years.

On this mortgage, let’s assume that I’ve to pay 12% curiosity however on decreasing steadiness rule.

How you can mathematically show, if this methodology of gadget buy financing is healthier or I can buy it immediately utilizing money (no mortgage methodology).

Introduction

Shopping for a top-end iPhone is now not only a easy buying resolution. It might probably transform monetary puzzle if we resolve to to not purchase it utilizing plain money. Like what’s occurring with certainly one of my readers (above question).

Within the e mail, the particular person disclosed that as the value touched 2,00,000, he pause for a second to rethink his shopping for technique.

He’s considering, Ought to this cash go straight from his checking account, or can or not it’s put to work earlier than the large buy?

That is the place the thought of utilizing a Fastened Deposit whereas taking a private mortgage is available in.

It sounds intelligent as a result of on one facet we are able to earn curiosity on our FD whereas we pay EMIs on the mortgage.

We merely need to perceive what occurs mathematically when the FD solely earns 6.6% whereas the private mortgage prices 12%.

This brings us to this query that’s it actually value paying 12% curiosity on mortgage and earn solely 6.6% on FD?

The Primary Setup

You need to purchase an iPhone Professional Max 1TB value about Rs. 2,00,000.

You have already got Rs. 2 lakh sitting in your checking account. On paper, the simplest method is to pay out of your financial savings and stroll out with the telephone. No curiosity, no commitments.

However suppose your financial institution offers you an alternative choice. You place that Rs. 2 lakh in an FD for 5 years at 6.6% annual curiosity (compounded yearly). Towards this FD, you get a completely financed private mortgage of Rs. 2 lakh.

As a result of it’s a secured mortgage, banks typically lend the identical quantity as your deposit. The mortgage runs for five years at 12% curiosity with decreasing steadiness EMI.

However now the query is, if the FD grows at 6.6% and the mortgage is costing me 12% (virtually double), is it value contemplating this methodology of iphone financing or not?

Step 1: Understanding the Mortgage’s Cashflows

A 12% every year charge turns into 1% monthly in EMI calculations (roughly).

The mortgage is Rs. 2 lakh for 60 months.

Once we apply the usual EMI formulation (decreasing steadiness methodology), the EMI involves about Rs. 4,453.50. It is a regular determine for unsecured loans in India of this dimension and tenure.

Now, we’ll multiply the EMI with the variety of months (= 5*12). The overall reimbursement works out to roughly Rs. 2,67,210 (= 5553.5 x 12 x 5).

You may consider this as you iphone costing you about Rs. 2 lakh plus an additional Rs. 67,210 in curiosity unfold over 5 years.

That is the price of comfort and capital availability.

For most individuals, that is the place the story ends. Mortgage equals further curiosity. However with an FD backing this mortgage, the second a part of the equation turns into vital.

Step 2: Future Worth of FD

A five-year FD at 6.6% annual compounding grows slowly.

Making use of the compound curiosity formulation, the Rs. 2 lakh turns into roughly Rs. 2,75,300 on the finish of 5 years.

This progress of Rs. 75,000 is the full curiosity earned on the FD.

Now we are able to draw the conclusion extra clearly. Examine the Rs. 75,000 (FD curiosity) with Rs. 67,000 (mortgage curiosity).

From this comparability, we are able to conclude that the FD route is clearly higher. However, I feel, that’s an oversimplification (see the applying of current worth idea in step 4).

However that is true that once we place each quantities facet by facet on the finish of 5 years, the FD leaves you with round Rs. 7,790 greater than what you paid in EMIs.

It’s not an enormous distinction, however it’s constructive. Meaning the FD-loan methodology technically wins.

Step 3: Why 6.6% “Beats” 12%

At first look, it appears absurd:

FD earns solely 6.6%
Mortgage prices 12%
But, the FD + mortgage route comes out barely higher than paying money.

How is that even attainable?

The important thing cause is the decreasing steadiness methodology on the mortgage.

• Your FD curiosity is calculated on the full Rs. 2,00,000 for all 5 years (with compounding).
• Your mortgage curiosity at 12% is calculated on a “shrinking principal.” It means, each EMI you pay reduces the principal. So subsequent month, curiosity is calculated on a decrease quantity, then decrease, and so forth.

So the 12% is not 12% on Rs. 2,00,000 for all 5 years. It’s 12% on a steadiness (decreasing principal) that retains taking place.

That’s why, in rupee phrases:

• Whole curiosity paid on mortgage (at 12%) = ~Rs. 67,000
• Whole curiosity earned on FD (at 6.6%) = ~Rs. 75,000

Despite the fact that the mortgage charge is “increased”, you pay it on a shrinking base. The FD charge is “decrease”, however it’s earned on the complete quantity.

This hole is what creates that small internet profit (round Rs. 7000) in favour of the FD + mortgage route.

It feels counter-intuitive while you solely take a look at percentages, however an in depth calculation explains why it’s so.

Step 4: The place Current Worth (PV) Comes In

Now, let’s tackle an important query.

Ought to we additionally think about the current worth of the FD maturity worth (Rs. 2,75,000)?

Strictly talking, sure. That’s the extra appropriate method to consider it.

Once we say:

• FD matures to Rs. 2,75,000 after 5 years
• Whole EMIs paid are Rs. 2,67,000

After which we merely subtract: 2,75,000 – 2,67,000 = Rs. 8,000 achieve, we’re implicitly assuming that:

• Rs. 1 right now and Rs. 1 after 5 years are “equal”.

In actual life, that’s not true. Cash right now is extra precious than cash sooner or later. That’s precisely what PV tries to seize.

A extra correct solution to arrive at a extra optimum conclusion is that this:

1. Take the internet profit on the finish of 5 years (round Rs. 7–8k).
2. Low cost it again to right now utilizing an affordable charge (danger free charge).

For instance, if the web achieve after 5 years is, say, Rs. 8,000 and also you low cost it by an element of seven% per yr, the current worth of that achieve is roughly:

PV ≈ Rs. 8,000 / (1.07)^5
≈ Rs. 8,000 / 1.40
≈ Rs. 5,700

So, in right now’s phrases, the “actual profit” of doing the FD + mortgage mixture may be someplace round Rs. 5,700.

Someonw may say, it isn’t an enormous quantity. However it’s nonetheless constructive.

Comparability Desk

Conclusion

What appears stunning at first is definitely very logical as soon as we perceive how mortgage arithmetic works.

Despite the fact that the FD earns solely 6.6% and the mortgage prices 12%, the FD route nonetheless seems barely higher than paying money.

This occurs as a result of the mortgage curiosity is calculated on a decreasing steadiness.

The EMI paid every month retains chopping down the principal. So, the 12% isn’t charged on the complete Rs. 2 lakh for the complete 5 years.

However the FD earns curiosity on the complete Rs. 2 lakh each single yr.

That distinction, shrinking mortgage vs. full FD, creates the small monetary benefit.

[Please Note: The point at which both methods would cost exactly the same, the break-even FD rate comes to around 5.8% for the same loan structure. Below that rate, buying with cash becomes better. Above it, the FD-plus-loan strategy starts giving you a net gain.]