Indians love gold and even the poorest Indian tries to acquire the smallest trinket that doubles up as jewellery and long-term savings. Naturally, television advertisements featuring movie superstars who tell you how easy it is to borrow money against that carefully accumulated gold, touch an emotional cord.
Watching an Akshay Kumar slipping gold across the counter and getting a wad of cash back in a minute to finance a child’s education or to buy a tractor is so appealing that people across the economic spectrum look at gold loans as their first borrowing option, when they are in a tight spot. In almost every case, the gold that is pledged is not even a family heirloom of great emotional value and borrowers are clueless about the high interest they are forking out against an asset which fetches no return—one where although price appreciation has worked for Indians, over the decades, it is not guaranteed.
This emotional reaction and poor numeracy also makes lending against gold a very lucrative business. Allow us to explain why borrowing against gold is a mistake for most people, except those who own heirlooms of antique value far beyond the intrinsic value of gold in the jewellery.
Some Basics about Gold Loans
Borrowing against gold is attractive because few questions are asked. The lender does not ask you to disclose your income, produce a salary-slip or worry about your credit score or credit report. But think about it; why should the lender worry? It has your valuable gold in its possession and the actual loan disbursed is just 75% or less than the market value of gold. The lender is in trouble only if the gold price crashes by 30%+. But past data shows that a sudden crash in gold is a remote possibility, if not impossible, and when the price falls, lenders immediately begin to pressure the borrower to either pay back a part of the loan or bring more gold/jewellery as collateral.
In most cases, only the interest is charged on a monthly basis, and the principal can be repaid at the end of the tenure to release the gold. The borrower can opt to repay both the interest and principal at the end of the tenure as well. However, the latter will prove to be costlier as the interest gets compounded. If a person defaults on interest payments, the penalty can be huge. Like every other loan, lenders may charge a processing fee, valuation charge, late payment penalty and pre-payment penalty, all of which add to the costs. Each lender has a different set of charges. Unlike equated monthly instalments (EMI), both repayment options involve pressure on the borrower to come up with a big chunk of money for repayment, to have the gold released. If you can, indeed, come up with such a sum, wouldn’t it be better to sell the gold and buy when you have the money? We will come to the arithmetic of this later.
Faster Process but Not Transparent
Most non-banking finance companies (NBFCs) claim that they offer a loan of 70%-75% of the market value of gold item. However, when we asked for the exact amount, we were told that only once they see the jewellery, they would be able to give the exact loan to value that can be availed. Even a RBI working group found that the borrower is generally not clear about the gold price used for valuing the ornaments.
The RBI working group found that the format and content of documentation followed by each NBFC appear to be different, although each one of them claims to be giving a pawn ticket and loan agreement copy to the borrower. But when they spoke to complaining borrowers, they found that the pawn tickets do not contain the specific details of the jewels pawned, their weight in grams and the assessed value of the jewels. It does not contain complete details of the annualised rate of interest, maturity period of loan, details of auction procedure in case of default, any other charges, or the maturity period of the loan, etc.
The procedure relating to auctioning of jewels is not transparently explained to the borrower. Even though the borrower is informed by the NBFCs about the auctioning of their jewels, the borrower is not informed where and when the jewels are auctioned.
In one complaint received by RBI, the borrower was neither informed about the auctioning of his jewels nor called for repaying his loan. Above all, though the market value of ornaments in this case was much above the total dues outstanding, the difference on the sale of ornaments was not given to the borrower. But let’s us now come to the simple math of why borrowing against your gold makes little sense.
The Actual Cost of Gold Loans
When you borrow against gold jewellery, you are paying a very high interest as well as documentation, processing and valuation charges on an asset that you already own. Further, since people only borrow against gold in an extreme emergency, the chances of paying back within a year are low, which means that the interest mounts and the risk of default is also higher. Let’s look at a few possible scenarios to check if taking a gold loan is worthwhile.
We have based our study on the cost of a gold loan from Mannapuram Finance. We were told that the interest rate will be 2% per month(pm) and the loan-to-value (LTV) will be around 70%. There are tenures of maximum three months; hence, at the end of each quarterly period, if only the interest is paid, the loan can be extended for another three months. This can go on until the entire principal is paid back. However, as the contract is renewed every three months, the borrower may need to pledge additional gold, if the price of gold falls and does not meet the LTV criteria.
Using the above information, let’s say Ramesh pledges 50gm of gold to avail a loan of Rs1 lakh at an interest of 2% per month. The market value of the gold is Rs1.44 lakh at the rate of Rs2,880/gm.
Now let’s analyse what Ramesh will actually pay under different repayment options and when gold prices are rising or falling. We will then compare this to whether selling the gold and buying it back in small lots every month would have been a better option for Ramesh.
Scenario 1: Gold Rates Remain Steady
The interest on a gold loan of Rs1 lakh works out to Rs2,000 per month. We assume Ramesh is capable of repaying Rs3,000 every month which includes interest and principal. At this rate, it will take him almost 56 months, or five years, to pay up the money and get his gold back. If Ramesh chooses to reduce the monthly payment by Rs500 to Rs2,500, it would take him nearly seven years to pay back the loan.
On the other hand, if he had chosen to sell the gold, instead of borrowing against it, he would have needed to sell only 35gm of gold to raise Rs1 lakh. Now, if he starts buying back gold worth Rs3,000 (equal to his repayment of principal plus interest in the above-mentioned scenario), he would have recovered his 35gm of gold in just 33 months or under three years.
Even if he bought back gold worth just Rs2,500 every month, he would have his gold back in 39 months. And he would not have paid heavy interest and processing charges to a gold loan company. But one may argue that gold prices may not remain the same and they could rise sharply, making a loan option more attractive. Or, as has happened recently, gold prices could fall too. Let us look at what would happen to Ramesh’s borrowing under these two scenarios.
Scenario 2: Gold Rate Rises
Suppose Ramesh sold 35gm of gold (as mentioned above), but gold prices began to rise by say, 6%-10% every year. Even in this situation, if he buys gold worth Rs2,500-Rs3,000 every month, he would still be able to buyback the entire amount of gold in four years. If the gold price rises more sharply, at 12%pa, it will take Ramesh about 50 months (a little over four years) to buy back the gold. In effect, even when gold prices rise, it makes better sense to sell the gold you have and buy it back, rather than borrow against it.
Scenario 3: Gold Rates Fall
If Ramesh has pledged gold to raise Rs1 lakh and gold prices fall, then he could be in serious trouble. On the other hand, if he sold gold to raise emergency funds and is buying it back, he is a real winner. Consider what happens if Ramesh had borrowed against his gold. If the price of gold declines significantly, he will need to pledge additional gold to maintain the loan to value ratio or repay a chunk of the money. Our analysis shows that Ramesh will need to pledge additional gold only if gold prices decline by 15%-20% on an annual basis. Also, if the LTV increases, the financier can charge a higher interest.
In the above scenario, a 12% decline in gold prices may not impact the value of gold pledged, if the amount repaid is Rs3,000 every month and includes a portion of the principal. However, Ramesh is capable of repaying only Rs2,500pm, with a very little part of the principal being repaid, he will need to increase the gold pledged amount by one gram at the end of the first year itself. By the end of the tenure, he would need to pledge an additional 3.25gm of gold, or pay a higher interest, in which case, his repayment period increases.
There is a also a good chance that he will not be able to keep up with this high interest cycle and end up losing the gold altogether or end up in a payment-trap, if he wants the same gold back.
On the other hand, if he had sold the gold and raised money and bought back even Rs2,500 worth of gold every month (using the money saved on interest), he would be able to buy more gold every month, as prices fall and get his gold back in less than three years.
The Reality
Clearly, liquidating gold to generate cash and buying it back at regular intervals is a much better option. It is foolish to pay a fat interest on an asset that you already own and take the risk of a penalty or losing the gold if you are unable to repay it in time. What is important is to avoid the emotional trap involved in wanting to retain the very same gold ornaments. Apart from a few gold ornaments, like a wedding or engagement ring, a mangalsutra, or a traditional piece of jewellery that has been handed down a few generations, there should be really no emotional attachment to an inert metal object. Also, most sensible women actually like to save carefully and make newer and better ornaments by melting down old ones. And many women also own jewellery that is gifted or handed down to them that they would be happy to sell and buy something new, contemporary and modern. It is far smarter to trade soppy sentimentality for good financial sense. So, the next time you hear of someone caught in a financial jam, tell them to switch off the gold loan advertisements and do some hard number-crunching.
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The RBI also found that a major proportion of the gold loan portfolio of NBFCs covers an average interest rate of 24%-26% and only 2% of their portfolio comprises loan at an interest rate of 12%. It is always said that the poor in India pay much more and the RBI report confirms this. It found that those in the unorganised sector pay 30%pa (per annum) and higher penalties and there was less transparency in the transactions. Even otherwise, the RBI report found that a majority of the gold loans are for borrowing of Rs30,000 to Rs50,000 and the quantity of gold pledged on an average is 40 grams.
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India is a gold-loving nation and accounts for about 10% of the total world gold stock. Of this, rural India accounts for nearly 65% of gold owned, probably because it is seen as the safest asset. Most people have an emotional attachment to gold and will not sell it except in times of extreme financial distress. This is what makes gold loans such an attractive business for lenders. While the unorganised sector accounts for 75% of gold loans, the remaining 25% of the market, with organised sector institutions and banks, is also growing rapidly. According to the World Gold Council, out of the national gold stock of around 22,000 tonnes, about 600 tonnes is monetised through loans because they are easy to obtain and processed within hours, if not minutes, as claimed by the advertisements. It is clearly time to be less emotional and more sensible about gold.
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