Happy New Year 2020 folks! We start the year with an explainer on Zero cost EMIs. This is when you are told: Take this product at 0% EMI for six months! And you wonder why.

This is an interesting way that Bajaj Finance used to grow cons durable loans – later copied by banks which got rapped on the knuckles by RBI. This is a thread from Twitter.

### What is a Zero Cost 0% EMI?

You can buy something for Rs. 20,000. But someone offers you an interest free EMI loan for, say 6 months! As in you pay Rs. 20,000 / 6 = 3333 per month and take this thing. No processing charges, no other charges, so you’re like why?

Obviously paying over 6 months is better than paying all at once. Some interest will be earned by your money simply sitting there in your bank account.

But what’s in it for the shop? For the finance company?

Now three entities need to be satisfied – the shop, the manufacturer of the thing, and the finance company. You might just walk away saying Rs.20,000 is too much, I’ll come back the next time. No one makes any money.

But at Rs. 3,333 a month, you’re like: I can afford that.

To entice you to buy, they work together.

1) The manufacturer says ok, if the customer takes this 3,333 per month deal, I’ll provide a 5% discount on the product (but not to the customer)

2) The Customer pays 20K, but the financier gives the manufacturer just 19K (5% less)

3) The manufacturer pays a commission to the shop. Possibly 10-20% or so, which would be the same even if customer hadn’t taken the loan – but at least this ensures a person becomes a customer.

4) The financier, you think, is getting screwed. He pays 19K to get back just 20K in six months? That’s just 5% over 6 months or 10% annualized? Isn’t that too less? We will now introduce you to the magic of “cash flow”.

### The Magic of Cash Flow

The financier doesn’t get 20K back after 6 months. He gets Rs. 3333 from you every month for six months. In effect, you are paying back principal every month (and some interest)

What’s the interest rate earned by the financier?

Remember, the financier pays 19K now, gets 3,333 for the next 6 months. That’s a whopping 19% interest.

How is this calculated? A simplistic way to look at it is, you pay back every month.

Think of this as:

- Month 1: the outstanding loan is of Rs. 19,000, you’ll pay some interest on this amount
- Month 2: Since you’ve paid Rs. 3,333, the net outstanding loan is that much lesser (around 16,700) and you’ll pay interest on the lower amount
- Month 3: Another 3,333 is paid, and the outstanding falls to Rs. 13,000 or so
- Month 4: Yet another 3,333 is paid and the outstanding falls to Rs. 10,000 or so
- and so on until month 7 when the full loan is repaid

Mathematically, the 19,000 goes to zero in 6 months, so the average tenure of the loan is around 3 months. The Rs. 1000 earned in three months on the 19,000 is about 5%. So 3 months and 5% = 12 months and nearly 20%.

If you assume a constant interest rate through the process, you can calculate this through a formula in excel called IRR (Internal Rate of Return) of a cash flow.

Or use the formula RATE(6, 3333.33, -19000, 0) to get an approximation (will show 18%).

For a Bajaj Finance this works well – they will be able to lend out the money they earn to other customers every month. But it gets better.

Sometimes they say, just pay 1 EMI in advance. That’s ok, you think. But what the financier makes, on just 1 advance EMI, is a whopping 27% interest.

That’s a sweet deal for the financier. Then credit cards started to offer this deal.

### Banks and Credit Cards Regulated

Credit cards are issued by banks and banks are regulated by the RBI. NBFCs like Bajaj Finance are more lightly regulated so they escaped the RBI view.

Unfortunately, RBI told banks: yo, excuse me, if you’re getting a 5% discount from manufacturer, you *must* allow customer to get that discount too.

So now, when you get a zero-EMI offer from a credit card, they tell you, in a convoluted way, that you pay an interest etc. But they still don’t offer the discount to you yet (which is a violation of RBI rules but no one’s seemed to complain yet)

Note: Credit card interest will also attract GST, apparently, so banks make a lot lesser from it as some part of the interest collection will go to GST.

### Overall: A Win for Everyone

This, as a whole, is a good thing. The manufacturer doesn’t want to discount the product unless you’re absolutely willing to buy. The shop doesn’t care (but the 27% interest rate is high enough for the financier to pay a little extra commission to the shop also)

And for you, if you keep the money in a liquid fund at just 6%, you’ll make back like Rs. 350 in interest – which is about a 1.5% discount for you, effectively. The difference between a 5% and a 1.5% discount isn’t all that much to bother really. So you do win.

Effectively, this is great for commerce. The financier takes the risk that you won’t pay, but that’s not as much a risk really – the dishonest people are small in number anyhow. With a 27% interest rate you can easily take a few losses.

We explain some of this in our podcast: **Click here to listen**.