Question

Blair has a 5-year personal loan with the bank. He currently makes an equal quarterly repayment at the end of each quarter at an interest rate of 7% p.a. compounded quarterly. Which of the following may reduce the total cost of the loan? (There may be more than one correct answer. You will lose marks by choosing a wrong answer. The minimum mark for the question is zero.)

Select one or more:

a. To renegotiate the interest rate to 7% p.a. effective.

b. To delay the first repayment to the end of year 1 and repay the loan over the 4 remaining years.

c. To ask for an interest-only period of the first 2 years of the loan term.

d. To change the repayment plan to an equal monthly repayment at the end of each month.

e. To renegotiate the loan term to 10 years.

Answer 1

The current interest rate on the Loan is 7% compounded quarterly.

So the Effective Interest Rate =(1+7%/4)^4-1=7.186% pa.

So the total cost of the Loan may be reduced by the following ;

a. By re-negotiating the interest rate @7% pa , the effective rate will be less than the current effective rate of 7.186% pa.. So the total cost of the loan will be reduced.

d. By changing  the repayment plan to an equal monthly repayment at the end of each month instead of current quarterly installment payment. In Monthly payment mode , Principal amounts will be repaid at faster interval than quarterly mode, so the overall interest cost during the loan period  will be lesser in monthly installment than in quarterly installment.

Option b will not reduce the cost as the delay in repayment till the 1st year end will cause higher interest as no principal will be repaid during 1st year and the effective interest burden over the loan period  will be higher.

Option c will not reduce the cost as during the first two years of interest only period , no principal will be repaid. So the overall interest burden over the loan period  will be higher.

Option e will not reduce the cost as loan term will be extended by another 5 years , so overall interest burden over the longer loan period  will be higher.

Therefore ,  option a & d. are correct.