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How increase in Interest Rate can kill your Financial Freedom?

Your teaser loan will really tease you

Yesterday my financial calculator was creating some problem while calculating a home loan EMI case. The issue was like this. My customer has taken a 20 year home loan of 32 lakhs 2 years back at 8% interest and was paying the EMI of Rs.26,766/-.  The loan was on floating rate, but the interest was fixed at 8% for the first 2 years and market rate from 3rd year.

My customer was not in a position to afford a higher EMI now, because the interest rate is increased to 10.5%. So he wants to increase the term of the loan. I want to calculate, by how many years, his repayment will increase, because of this 2.5% increase in interest rate. While doing the calculation, the message flashing in the calculator screen was ‘’Math error’’!

While my calculator was perfect till that time, I thought some technical problem has occurred and I have to repair my calculator. Anyway I decided to consult my Guru, Mr. Sunil for a second opinion. I told him the data over phone and he told me that his calculator is also showing the same error message!  How it can be?

I had the biggest shock in my life when my Guru called me after 30 minutes. He asked me to calculate the outstanding loan as on date. It was 30, 59,112/-. Then he asked me to calculate the simple interest on this at 10.5%.It is coming to 26,767/- per month – one rupee more than the current EMI at 8%. This means, if my customer continues to repay the same EMI, the bank has to adjust the entire EMI amount towards interest and not a single rupee is going to repay the outstanding loan! The outcome – the customer has to keep paying this amount as if he pays the interest only and he or his legal heir has to repay the entire loan later over and above the EMI! My calculator was perfect in showing this as an error message, because this loan will never close with this EMI.

Shocking? But this is going to be the issue with lot of home loan borrowers who have taken home loan under the so called Teaser Loans.

Maths behind the EMI

In the above example, the amount of principal repaid in the first 2 years comes to Rs.1, 40, 888/-. So the outstanding loan at the end of 2 years comes to 30, 59, 112/- (3200000-140888 = 30, 59,112).In such long term loans, the principal repayment will be very small in the initial years because majority portion of the EMI is going towards interest. In this example, he has paid Rs.501496 towards interest in the first 2 years!

So, if he is not ready to increase his EMI, the loan will never be over and it has to be repaid by other means than the EMI! If an increase of 2.5% can make this much problem, you can imagine the fate of many home loan customers where RBI has increased interest rates by around 3.5% in the last 15 – 17 months. Home loan rates are in the range of 10% to 13% now. Are we going to see lot of loan defaulters and a US like crisis?

How to escape from this Trap?

Now let us see how, he can handle such a situation There are many alternatives.

Option -1

If he can afford, the viable option is to pay the higher EMI without increasing the term of the loan. In our example, at 10.5%, the revised EMI will be 31,577/- instead of 26,766/- which he was paying for the last 2 years. An increase of Rs. 4811/- or 18%!

Option – 2

Go for a combination of increase in term of the loan and a moderate increase in EMI. In the above example, if the term of the loan is increased by another 5 years, the EMI will be 29,425/- an increase of Rs.2659/- or around 10%. This will be affordable by most customers because, there would have been atleast 8-10% increase in salary in the 2 year period. But the total outgo on interest in this option will be 55.63 Lakhs compared to 42.63Lakhs in the first case!

Option -3

If you can partly prepay the loan regularly, that will act as the best option for you. Let us imagine, in the above case the customer is prepaying 1 Lakh at the end of every year from his annual bonus and maintain the same EMI of Rs.26, 766/-. Let us see, how the situation looks like.

Year opening balance in loan account Principal repaid from EMI outstanding loan at the year end Prepayment of 1 Lakh at the end of every year Actual outstanding loan at the end of the year
1 3200000 67637 3132363 100000 3032363
2 3032363 81551 2950812 100000 2850812
3 2850812 22941 2827871 100000 2727871
4 2727871 36488 2691383 100000 2591383
5 2591383 51530 2539853 100000 2439853
6 2439853 68228 2371625 100000 2271625
7 2271625 86768 2184857 100000 2084857
8 2084857 107350 1977507 100000 1877507
9 1877507 130201 1747306 100000 1647306
10 1647306 155570 1491736 100000 1391736
11 1391736 183735 1208001 100000 1108001
12 1108001 215004 892997 100000 792997
13 792997 249718 543279 100000 443279
14 443279 288258 155021 100000 55021
15 55021 52799 2222

You can see in this case the total interest outgo will be Rs.27.50 Lakhs only and the loan will be over in 170 EMIs of Rs. 26,766/- and annual pre payment of 1 Lakh for the first 14 years.

Conclusion

1.    Home purchase is one of the important financial decisions in every body’s life. Atleast 3 year before the home purchase, reduce the luxury expenses and save more towards creating a high down payment so that the loan amount can be reduced. Money saved at this stage will contribute a lot towards the financial well being in future because of the power of compounding.

2.    Go for a house within your budget, after analyzing the repayment capacity. Don’t go by the loan eligibility, because a small increase in interest rate can derail your budget. Don’t allow your EMI outgo, to exceed more than 40% of your net salary.

3.    Ensure that you are allotting some amount every year towards part prepayment of the loan. This will help you in closing the loan early and start saving for other financial goals in life.

4.    Ensure that your home loan is insured. Most of the home loan providers are selling Mortgage redemption policies along with the loans. The premium rates are very high for these policies and they are deducting it along with EMI. Don’t opt for it, buy term insurance policy instead. If you are taking a home loan of 30 Lakhs for a 20 year term, take a 30 Lakhs term insurance for 25 years. This will ensure that you have the same level of cover, even if the term of the loan is extended by another 5 years. You can buy term insurance policies online, with very low premium. Aviva Life, ICICI Prudential, Kotak Life etc. offers better policies.

5. Please note that you are also planning for other major goals like Children Education/Marriage and more importantly your own Retirement so that situations like Reverse Mortgage can be avoided.

Everybody should have a home. Plan for it in such a way that, it will not tease you.

3 Comments

  • Melly Thomas Posted August 19, 2011 11:08 am

    Excellent article, clearly explaining many things in simple words for a home loan borrower. It is true that we must limit the loan amount to our repayment capacity and not to our loan eligibility. Today again ICICI Bank started offering the loans at fixed interest rate for the first 2 years. will it be advisable to for such loans now?

  • Prasanna Posted September 16, 2011 12:28 pm

    Home loans are anyhow attractive if it is taken for residing. but as investment or to escape from the taxation people go for another home loan. In India, by saying the fundamentals are strong, the banks are really exploit the public and business men. Compared to growing and grown countries outside India, Indian banking policy sucks.

  • rohan Posted March 27, 2014 2:17 pm

    To escape this scenario i always recommend one should go for fixed rate of interest, Although its 0.50% more than flexible at time of taking loan but in long term it will protect you from high EMIs. for eg: PNB housing offers fixed rate for period of 10 years whereas banks like ICICI offers fixed interest rate loan for duration of 3 years.

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