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 3^rd 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.

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.