Rishi Awasthi and Vidhu Sarkar are finding it difficult to cope with the burden of their home loans. Rishi, a senior engineer based in Delhi, took a loan of Rs40 lakh in 2003, when interest rates were at historic lows. Since then rates have risen substantially, and with them, Awasthi’s equated monthly instalment (EMI) has also escalated far beyond his worst-case estimates. Vidhu Sarkar, a Mumbai-based technical analyst, took a home loan from a private bank but now finds that a public-sector (PSU) bank is offering one at a lower interest rate. He is contemplating switching to the PSU bank but is concerned about the penalty that the private bank might levy. First, we shall discuss a few basic facets of home loans, and then provide answers to the dilemma that Awasthi and Sarkar face.
How much can you borrow?
The amount of loan that a borrower is eligible for is determined by his income. Some of the other criteria that banks take into account are age, qualification, spouse’s income, number of dependants, stability and continuity of occupation, savings history, and other loans that the borrower may have taken.
For instance, if your monthly income is Rs30,000 and your monthly expense is Rs12,000 you have savings of Rs18,000 every month. If you have no other liability, banks will calculate your loan eligibility by the following formula:
Amount you are eligible for: (Monthly savings/ per lakh EMI).
On a home loan of Rs1 lakh at an interest rate of 10.5 per cent for 20 years, the equated monthly instalment (EMI) would be about Rs998.
In this case, (18,000/998)*100,000 = Rs18,03,607. That is the maximum loan amount that the customer is eligible for.
Floating- versus fixed-rate loans
In a fixed-rate loan, the rate of interest is fixed either for the entire tenure (such products hardly exist today) or for a certain period. Most fixed-rate loans usually come with a reset clause that allows banks to revise the interest rate from time to time. The advantage of a fixed-rate loan is that your EMI liability remains fixed. Besides offering mental comfort, this is more conducive for planning your finances. The flip side, however, is that the rate of interest is much higher than that charged on a floating-rate loan.
The EMI of a floating-rate loan, on the other hand, changes as the bank’s benchmark rate, the base rate, changes. When interest rates within the economy rise, banks too raise their base rates and then the EMI of floating-rate loans gets revised upward. The advantage of this loan, however, is that when interest rates fall, the EMI also falls.
Loan-to-value (LTV) ratio is the percentage of the value of the property that the bank is willing to give as loan. Higher the LTV ratio, easier it is for borrowers to buy a property. But with a higher LTV the lender’s risk increases. To reduce banks’ risks, the Reserve Bank of India (RBI) has asked banks to maintain a margin of at least 20 per cent of the value of the property (that is, the LTV ratio cannot exceed 80 per cent). Earlier, this margin varied between 10 and 15 per cent. However, on lower-value loans of up to Rs20 lakh RBI has allowed LTV of up to 90 per cent.
Says Veer Sardesai, a Pune-based financial planner: “RBI has taken this step to control realty prices. A higher LTV will ensure better quality of assets for banks. For borrowers too this will be beneficial in the long run as their total interest outgo on the loan will decline. However, they will have to arrange for a bigger sum of money at the time of purchase.”
Spiralling interest rates
Due to high inflation, interest rates have risen steeply in recent times. Between April 2010 and March 2011, RBI increased the repo rate by 150 basis points (bps) and the reverse repo rate by 200 bps. Banks too followed suit, hiking their own benchmark rates.
In the last quarter of 2003, floating-loan rates had fallen to around 7 per cent. Thereafter, they rose to around 10 per cent by January 2007. Currently they are in the range of 11-13 per cent. However, borrowers can take solace from what Sardesai says: “From the current levels, I do not expect interest rates to move much further, at least in the next six months to one year.”
Options before borrowers
Switch from floating to fixed: Fixed-rate loans carry a higher rate of interest. The borrower may also have to pay a fee for switching from floating to fixed. Moreover, we are now near the peak of the rate cycle. Therefore, it does not make sense to move from a floating- to a fixed-rate loan.
Shift to other lenders offering lower rates: If one looks around, one can find differences in the interest rates charged by different banks and take advantage of this. However, as Sardesai suggests: “A switch only makes sense if the rate differential between the existing loan and the new loan is 2 per cent or more.” Moreover, keep in mind the prepayment penalty that your current lender will charge.
Should you increase the tenure? When interest rates go up, the bank provides you two options, or a combination of both: pay an increased EMI while keeping the tenure constant; or increase the tenure while paying the same EMI. Which is the better option of the two?
Most people would have already stretched themselves financially at the time of taking the home loan and hence find it difficult to pay a higher EMI. They therefore prefer to increase the loan tenure. But as Sardesai says: “Keep the loan tenure unchanged if you can handle the pressure of a higher EMI.”
It is not advisable to increase the tenure because when you do so, your total interest outgo on the loan increases substantially. Take the example of a home loan of Rs40 lakh at an interest rate of 12.5 per cent for 15 years. The total interest paid on such a loan would be Rs48,74,180. When the tenure of the same loan is increased to 20 years, the total interest outgo rises to Rs69,07,040 — a differential of Rs20,32,860. Therefore, as far as possible,avoid increasing the tenure.
Should you prepay? If you decide not to increase the tenure, then another way you can prevent your EMI from going up is through part-prepayment of the loan. Many banks do not charge any penalty for part prepayment. Sometimes those that do not charge a penalty, however, fix a limit on how much you can prepay every month.
Whenever you get a windfall, part-prepay the loan. Part prepayment is especially advantageous in the initial years when a fairly high portion of your EMI goes into repaying the interest, and only a small component goes towards reducing the principal.
If you prepay the loan fully, your current lender may not charge you a prepayment penalty if you are making the payment out of your own funds. On the other hand, if you are switching to another lender, banks normally charge a prepayment penalty of around 2-2.5 per cent. The Finance Ministry has recently directed banks to waive off pre-closure penalty charges on home loans but banks are reluctant to implement this.
That is why at the time of taking a loan it is important to study the prepayment clause of that lender closely: go for the bank with the most lenient rules in this regard.
Loss of tax benefits: The flip side of prepaying a loan is that you lose out on the tax benefits. Under Section 80C, you get a tax deduction of up to Rs1 lakh on repayment of the principal. And under Section 24 (b), you are eligible for deduction up to Rs1.5 lakh on interest repayment.
Prepay or invest? According to Sardesai, “In the current high interest-rate scenario, few investment instruments will give you a post-tax rate of interest that is higher than the interest charged on a home loan. Equities may, but they come with an element of uncertainty.” So if you have surplus funds, says Sardesai, prepay the loan after taking into account the penalty charges.