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How to cope with rising interest rates on your floating rate home loan
Sunil Dhawan & Pankaj Anup Toppo
How badly is the EMI (equated monthly
instalment) of your home loan messing up your budget? Over the last
four years, the interest rate on home loans has risen from the bottom
of about 7.75 per cent in 2004 to about 12.75 per cent now for existing
customers. During the initial period of the rise, your lender bank or
housing finance company (HFC) increased the loan tenure, till it went
up to the end of your expected working life. Then it started bumping up
the EMIs. Your total interest burden would have more than doubled from
what it was in 2004 unless you have already prepaid substantial chunks
of your principal.
This larger loan burden comes at a
time when rising prices are putting pressure on your budget anyway. To
cap inflation, the government and the Reserve Bank of India (RBI) have
been tightening the screws on liquidity. The RBI has increased the cash
reserve ratio (the amount banks set aside with the RBI) and the repo
rate (the rate at which banks borrow from the RBI), sucking out cash.
So, banks are having to pay higher interest on deposits to bring in
cash. To make money on these higher-cost funds, they have had to hike
lending rates. This has pushed up the overall interest rates.
The biggest impact of this increase is on home loans. Those who took
fixed rate loans have been guarded against this since the rate is
likely to be reviewed after five years or so. However, those who took
floating rate loans have borne the brunt of the rate hike, seeing their
repayment tenures and EMIs shooting up.
While there have been reports of suicides over inability to repay home
loans in the US after the sub-prime crisis, we haven’t heard anything
such in India yet. But the task of making ends meet without losing the
roof over one’s head is stressing people out. So, how do you ease the
pressure, even partially?
THE SHOCKS
To find a way out, you have to understand how interest rates are set.
Banks calculate their own cost of funds from various sources. Above
that, they fix the prime lending rate (PLR), a rate at which they lend
money to their best or least risky customers. Normally, all banks also
fix a benchmark PLR (BPLR). All loans are linked to the BPLR. When
interest rises, the PLR and the BPLR increase. This, in turn, pushes up
the rates for the floating home loan buyers, since the rate of interest
they pay is linked to the BPLR. Then comes the increase in loan tenure
and, subsequently, EMIs.
Longer tenure, higher EMIs. Take the case
of a 30-year-old who had taken a Rs 30-lakh home loan in 2004. At an
interest rate of 7.75 per cent per annum then, he was supposed to pay
an EMI of Rs 24,628 for 240 months to repay his loan. Typically, most
banks provide a loan tenure of up to 240 months. The total interest
outgo over this period would have been Rs 29 lakh. So, the total cost
of his home would have been Rs 59 lakh. By 2006, when interest moved to
9.5 per cent on the same loan, on the same EMI, the tenure was pushed
to 26.61 years. A 1.75 per cent increase in the interest rate pushing
up the tenure by 8.61 years!
Higher interest outgo. Today the same loan runs on an interest rate of
12.75 per cent. Over the last four years, the bulk of what he has been
repaying as EMI is interest. So, he still has an outstanding principal
of Rs 27 lakh to repay and his EMI is up to Rs 29,774. This is what the
situation is: a loan, originally for 240 months with an EMI of Rs
24,628, gets rolled into one for 319 months with an EMI of Rs 29,774.
The horror story does not end there. On the outstanding principal of Rs
27 lakh now, the total interest burden for 26.61 years is a whopping Rs
68 lakh, and the total cost of the Rs 30-lakh home has become Rs 98
lakh, including Rs 3 lakh that has already been paid.
Higher total cost. Every time the interest rate goes up by 0.25
percentage points, the repayment period gets longer. For instance, on a
loan at 9 per cent, if the original repayment tenure was 240 months, a
0.25 percentage point increase after, say, a year lengthens the
remaining payback period by 11 months to 239 months. A 1 percentage
point increase prolongs the tenure by 60 months, taking the total
tenure to about 288 months (see With Every Hike). With the loan amount
constant, more the number of EMIs you pay, the higher the interest
cost, and, therefore, the total cost of your home.
Typically, for a buyer, it is difficult to look at his home in a
clinical sort of way. The emotions and other intangibles play a strong
role. He’ll usually try to cut back on everything else to retain the
house, even if its cost has gone way above what he was looking at when
he bought it. Even though he doesn’t, strictly speaking, own the home
yet, in his mind he does. Thus, selling is not really an option. So,
what can he do to reduce the financial pressure?
THE SALVAGE OPTIONS
Now,
to become debt free, he will have to repay the loan. To expedite the
process, he has to bring the total cost of the house closer to what he
was expecting to pay when he bought it, that is, he has to reduce the
interest outgo in some way. This would mean reducing the tenure, or
EMI, or both. There are three possible ways—switching, refinancing or
part-prepayment—to achieve this end. Let’s see how they work.
A. Switchover. To attract people to home loans, lending institutions
try to keep the interest rate for new loans as low a possible. At
present, it is around 11.50 per cent per annum on a reducing balance on
a floating rate loan taken for 20 years. This loan will be linked to a
BPLR and the interest rate on it will move with that BPLR. BPLR varies
across lenders largely dependant on the cost of funds. If you had taken
a floating rate loan, yours, too, would be linked to a BPLR, although
it would be different from the one for a new loan and you are likely to
be paying interest at around 12.75 per cent per annum now. You can take
advantage of the difference in interest rates for existing and new
customers by asking your banker to switch over your loan to the rate
applicable for fresh customers. This, however, comes at a cost.
Typically, the borrower would have to pay some percentage of the
balance outstanding, say 1.75 per cent, and 12.24 per cent service tax
on it, to avail the new rate of interest, which, again, could rise over
time. In this case, the tenure remains constant, while the interest
burden is slightly reduced.
In the example that we had taken earlier, the cost incurred to switch
over would be about Rs 53,000, including service tax. The outstanding
loan and the term of 319 months don’t change, but the interest reduces
to 11.50 per cent. The EMI falls to Rs 27,171 and there is an overall
savings in interest of about Rs 8 lakh (see The Options For Reducing
Your Interest Burden: Switching).
B. Refinancing. Not all banks charge the same rate of interest on home
loans. So, if you can find a bank offering a lower rate of interest,
you can refinance the loan—borrow from the new lender and pay off your
old one. Banks expect to make a certain amount of money by funding you
for some years. That amount is their expected future earning from you.
Now if you foreclose the loan, that stream gets truncated. To ensure
against that, banks impose a foreclosure penalty, through which they
recoup part of this foregone income. The full repayment penalty is
normally 1.75 per cent of the outstanding amount plus the service tax.
The processing fee, depending on the bank, is 1.0-1.5 per cent.
Refinancing is usually costlier than switching, but the overall savings
are more (see The Options For Reducing Your Interest Bur-den:
Refinancing). Here, the cost of closing the loan from the existing
lender and opting for a new one from another lender will cost Rs
87,000. Paying this reduces the loan tenure to 240 months and the
interest burden to about Rs 42 lakh assuming that your balance working
life is more than 240 months. The new lender will want to finish the
loan within your balance working life.
C. Part prepayments. The third option is to make lump sum or regular
part prepayments of the principal. Here you are going to the root of
your problem. If your principal outstanding goes down, so will the
interest you have to pay on it, whatever be the rate. Part prepayments
also decrease the tenure and, therefore, the total interest outgo. But
first, make sure there is no part prepayment penalty associated with
your loan. Be careful, DO NOT increase the EMI—the prepayment amount
should be in addition to your EMI. If you part pay the principal every
time you have money in your hands, it will reduce the number of EMIs
even at your higher rate of interest (see The Options For Reducing Your
Interest Burden: Regular Prepayment).
Almost all banks and HFCs allow part prepayment. The pay-off can either
be done on a monthly basis, or as a lump sum anytime during the year.
Banks have their own criteria of allowing part prepayments. For
example, the minimum that one can part prepay should be equal to at
least one month’s instalment.
D. Part prepayment along with switching or refinancing. You can also
combine either the switching or repayment options with the prepayment
option. For instance, if you find that you have some free cash in hand
and your bank or another one is giving new loans at lower rates, then
you could part prepay the principal to bring down the principal
outstanding and the interest outgo. After that, if you switch or
refinance your loan, with a lower outstanding principal, you can bring
down your EMI further. If you do combine, then make sure you make the
prepayment first, since the switching and refinance options will
calculate the cost of doing so on the reduced outstanding principal.
If you have enough cash to fully pay off your loan, you will have to
pay a penalty of around 2 per cent on the outstanding loan. To avoid
the penalty, you may pay off the entire loan, except one year’s
outstanding that you have to continue paying as EMIs.
Aftershocks. If you wish to exercise the switching option, there is a
one-time cash outflow. Getting your loan refinanced from a bank is also
a good option. The best thing about this option is that the tenure and
the interest burden reduces considerably, albeit at a cost higher than
that of switching. The best option seems part prepayment, wherein there
is no cost involved, except the opportunity cost that your prepayments
could have earned if invested in high-yielding options like stocks
where returns aren’t certain.
RAISING PREPAYMENT FUNDS
Remember,
the amount that you are going to prepay your loan with is not coming
back to you. Developments such as windfall profits from the
stockmarket, maturing of old investments, build-up of capital over the
years due to increase in salary, or a bonus might prompt you to go for
prepayment, in part or whole. Diversion from other tax saving
instruments can be explored. Close all dormant savings account and use
those funds to prepay. Use unutilised funds lying in our brokerage
accounts to prepay. Ring up your friends to ask them about the funds
that they owe to you and seek zero-interest loans from parents or close
relatives.
CONCLUSION
Before
you choose your option, you should examine the alternatives and the
costs associated. A period of indebtedness of 10, 15 or 20 years,
clubbed with the uncertainties of job and life, create an uneasy
situation. From a purely psychological perspective, it may be better to
pay off one’s debts. This strategy would appeal all the more to you if
you want to live in a debt-free world and own a home. You will get to
own the home earlier if you channelise your surplus funds towards
prepayment.
Interest rates are cyclical in nature and
considering that home loans are long-term commitments, there will be
some periods du-ring the tenure when rates move up and some periods
when they will move down. Prepaying allows you to own the home sooner.
With luck, by the time the rates fall the next time around, you may be
in a position to consider buying your second home. - sunildhawan@outlookindia.com
toppo@outlookindia.com
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