Zero cost EMI: How do finance companies afford this payment option?

Zero cost EMI (Equated Monthly Instalment) is a financial concept that aims to provide consumers with the convenience of purchasing goods and services without making immediate upfront payments. It has gained popularity in recent years, particularly in the context of consumer electronics, appliances, and even larger expenses like vehicles and home renovations. This payment model essentially allows individuals to spread the cost of a purchase over a predefined period while paying fixed monthly instalments, with the added benefit of not incurring any interest or finance charges.

Let’s delve into how zero cost EMI works and explore an illustrative example to understand its mechanics better.

Firstly, let’s understand how zero cost EMI works.

Zero cost EMI operates on the premise of offering a convenient and budget-friendly way for consumers to afford purchases that might be beyond their immediate financial reach. The primary idea is to break down the total cost of a product or service into smaller, manageable chunks paid over time. Unlike traditional EMI systems, where interest charges are often added to the principal amount, Zero cost EMI operates on the principle of deferred interest. It involves collaboration between the retailer, a financial institution (such as a bank or a non-banking financial company), and the customer. Here’s a breakdown of how the process works:

1. Product Selection – The consumer selects a product or service they wish to purchase through Zero EMI. This could be anything from a smartphone to a home appliance or even a vacation package.

2. Loan Approval – The consumer’s eligibility for Zero EMI is assessed by the lending institution. This involves checking the individual’s credit history, income, and other relevant factors. Once approved, the lender determines the maximum loan amount and tenure for which Zero EMI can be availed.

3. Principal Amount – The total cost of the product or service is divided by the chosen tenure. This results in the principal amount, which is the sum the consumer will be required to pay back over the specified period.

4. Monthly Instalments – The principal amount is then divided by the number of months in the chosen tenure. This monthly instalment remains constant throughout the repayment period, making it easier for consumers to budget and plan their finances.

5. Interest-Free – The defining feature of Zero EMI is that it does not include any interest charges. This is a significant advantage over traditional EMI schemes, where interest payments can significantly increase the overall cost of the purchase.

Let’s understand with the help of an example.

You are looking for an air conditioner worth ₹40,000 on Flipkart and as you move ahead to place the order, you are offered an option to pay that amount spread across 6 months. 6 EMIs of ₹6,668. No interest charges or processing fees.

The next thought you have is – ‘obviously there is some catch here’. Why would someone give me an option to pay over 6 months? That too without any fees/charges? The catch is – it is more to do with marketing and sales than finance.

There are 3 entities involved in this transaction. The platform (Flipkart), A/C Brand (Blue Star), and the finance company (Bajaj Finance).

Imagine you are a working professional who just got an offer letter from a company with a salary of ₹80,000. Shelling out ₹40,000 may not be possible for you. But if you have to pay ₹6,668 a month for 6 months, you feel like you have got a deal. Blue Star gets to sell more. Flipkart gets more commission.

But what about Bajaj Finance? How will it make money and get compensated for taking on credit risk? Blue Star will cut out a deal with Bajaj Finance. It will provide a 5% discount to Bajaj Finance. So Bajaj Finance will pay Blue Star ₹38,000 while it will receive ₹40,000 from the customer.

So, Bajaj Finance earns ₹2,000 only? No, Here comes the Cash Flow Wizardry: As months pass by, Bajaj receives EMIs, the outstanding amount decreases and so does the interest on it. It deploys these EMIs to give another loan and so on. On an annualised basis, it earns 19.44%!!

Compared to the cost of funds of 10%, this translates to Net Interest Margin (NIMs) of 9%. Not that bad. Plus Bajaj Finance gets to acquire the customer and cross-sell other products in the future.

When does this turn into a gimmick? If say Flipkart forgoes the discount it would have given you or Blue Star adds the cost of interest to the price of the product. Not much you can do here.

So to sum it up, Blue Star sells more products, Flipkart gets more commission, Bajaj Finance gets good NIMs & a customer to cross-sell and the customer gets a flexible payment option to buy the air conditioner by not having to pay the full amount upfront.

Conclusion

Zero Cost EMI is a financial solution that has gained traction by providing consumers with a means to make significant purchases without incurring interest charges. By collaborating with lending institutions, retailers can offer customers the flexibility of spreading payments over a specified period, making high-value items more accessible. With its benefits of affordability, predictable payments, and no interest, Zero Cost EMI has become a popular choice for budget-conscious consumers seeking to balance their financial goals with their purchasing aspirations.

Rohit Gyanchandani is Managing Director at Nandi Nivesh Private Limited