Home loan borrowers have reason to be worried. The RBI, in its bid to rein in inflation, once again increased the policy rates this October — the 13th such hike since March 2010. This may further push up interest rates and equated monthly instalments (EMIs) on home loans. Already, periodic resets by banks and housing finance companies have seen interest rates on floating rate home loans go up by around 2.5-3.5 percentage points over the last 18 months to nearly 11-11.5 per cent currently. This has had a telling effect on the EMIs of home-loan borrowers.
On a loan with a tenure of 20 years, a hike in interest rate from 8.5 per cent to 11 per cent increases the EMI on every Rs 1 lakh of loan by Rs 164. This may not seem much, but given that that the average home loan size in recent years has increased sharply (following the steep rise in cost of realty), the increase in overall EMI can be big enough to burn a hole in the pocket.
On a loan of Rs 30 lakh, on the above terms, the EMI would have increased by Rs 4,931, a formidable 19 per cent rise. If you are hurt by rising EMIs, how can you soften the blow? Here are a few suggestions:
In a scenario of rising interest rates, lenders usually offer borrowers the option of increasing the loan tenure to maintain EMI at original levels. Take the case of a borrower who took a loan of Rs 10 lakh for 15 years at 8.5 per cent, where the rate is later hiked to 9.5 per cent. The original EMI would have been Rs 9,847, but after the rate hike, the EMI has increased to Rs 10,442. If the borrower wants to continue paying the original EMI and not increase his monthly outflow, he could increase the tenure of the loan by around two years to 17 years.
Several borrowers choose to increase their loan tenure to continue with a business-as-usual scenario. However, this comes at a high cost in the form of increased interest outgo. In the above example, increase in tenure from 15 years to around 17 years increases the total interest expense over the loan period by almost 35 per cent (from Rs 7.7 lakhs to Rs 10.4 lakhs). On the other hand, maintaining the same tenure and increasing EMI would have increased overall interest paid by a much lesser 14 per cent to Rs 8.8 lakhs. So, to the extent possible, it is better to pay higher EMI than increase the tenure of the loan. Essentially, short-term pain for long-term gain.
Why does a longer tenure result in a sharp increase in interest outgo? EMIs are structured such that interest component in the initial instalments is higher than in the later instalments. It is the reverse in case of the principal component of the loan. A longer tenure pushes the unpaid principal further into the future. With a good proportion of principal remaining unpaid for more years, it continues to bear interest.
LIMIT TO TENURE INCREASE
There are also limits to which loan tenure can be extended. A key factor here would be the borrower’s expected working life, beyond which lenders may be averse to extending the loan tenure. Consider the case of a 30-year-old who borrowed Rs 30 lakh at 8.5 per cent for 20 years. His EMI would be Rs 26,035. If, after one year, the rate of interest increases to 9 per cent and the borrower wants to pay around the same EMI, the tenure would have to be extended from the remaining 19 years to around 21 years.
Further rate hikes to 9.5 per cent in the next year and to 10 per cent six months later will result in the tenure going up to more than 25 years, by close of which the borrower would be close to retirement age of 60. The rising age factor rate would thus make extension of tenure beyond a point infeasible and the borrower would have to look at other measures to tackle the EMI burden.
Also, lenders may have their own rules regarding loan tenures. For instance, HDFC’s maximum loan tenure is 20 years, subject to retirement age, while SBI’s maximum loan tenure is 30 years, subject to maximum age of 70 years.
With competition in the loan market high, borrowers could shift their loans to other lenders if they offer lower rates. Although frowned upon by regulators, many lenders have been known to offer lower rates to new borrowers than what they charge existing customers.
Borrowers however may have to contend with prepayment charges levied by existing lenders. While some market players have waived pre-payment charges following directives from regulators, others continue to levy this charge, at least in the case of loans refinanced from new lenders.
Prepayment penalty may range between 1 per cent and 3 per cent of the loan amount. The borrower needs to calculate whether the cost reduction benefit from refinancing is higher than the prepayment penalty. Before homing in on a new lender, scout around for the best interest rates. Also, it is important to take into account processing and other charges, which add to the cost of the new loan.
Instead of switching lenders, borrowers could also consider negotiating with existing lenders to reduce the EMI burden. This could be done by swapping unfavourable historical spreads (used to determine effective interest rate) with better prevailing spreads.
This may however entail charges (say 0.5 per cent on outstanding principal). A cost-benefit analysis will help determine whether the swap is worthwhile.
Borrowers with surplus funds from a windfall or a bonus can also consider using the money to pre-pay a part or whole of their loan. Prepayment reduces the outstanding principal and significantly shrinks future interest outgo. This also helps keep EMI at comfortable levels, despite increase in rates. However, one should prepay only after doing some simple math.
Consider the opportunity cost of the funds (whether they can be deployed better elsewhere). Here, one should compare the after-tax benefit of investment opportunities, and the after-tax cost of the loan. Home-loans carry tax benefits on both interest (up to Rs 150,000 on self-occupied houses and the entire interest payment on other houses), and principal payments (eligible for deduction up to Rs 100,000).
This also makes a case for settling other higher-cost loans such as credit card dues and personal loans before prepaying home loans. Finally, check implications of prepayment penalty, if any. Also, keep sufficient reserves for contingencies before prepaying the home loan.
It may not be a good idea to use funds meant for the long-term (such as provident fund) to prepay home loans, unless the differential in rates being earned and spent is very high and the EMI burden is reaching breaking point. For one, returns on provident fund are exempt from tax and hence have a high effective after-tax return (above 10 per cent in the higher tax slabs). But in case you must use the provident fund to prepay the home loan, make sure to replenish it as soon as possible in a disciplined manner.
Don’t panic, just tighten the purse strings
In trying to cope with the burden of a higher EMI, there is the time-tested remedy of curtailing non-essential expenses.
Reducing restaurant and movie outings, spending less on fuel by using public transport, and keeping a tight watch on expenses could generate excess funds which could used to prepay the loan or service the increased EMI.
Also, it is important not to panic and give in to knee-jerk reactions such as deciding to sell the house.
A house for self-use may be a worthwhile long-term asset, giving an owner a lot of financial and emotional security.
Interest rates move with cycles, and there are indications that the current upward movement may be close to its peak.
In fact, the RBI while raising the policy rate in October has signalled that further hikes may not be in the offing. At this point, borrowers should also avoid switching from floating rate loans to fixed rate ones (which are invariably costlier). Holding on to patience now may be a wise move. After all, this is not the first time that interest rates have shot up sharply.
The last decade has seen home loan rates touch highs of around 13 per cent before falling to lows of 7 per cent. This cycle too will turn.
Source – The Hindu