The housing sector has never had it so good -- till recently.
If you remember, in 2004, floating rate home loans were available at seven per cent interest. This was after they had slid from the highs of 13 per cent during the year 2000. As the rates came down, the greed mentality was there for all to see.
Most people, instead of going for a fixed rate of interest, went for a floating one -- hoping the good times would never end and rates will continue to go south.
If you told anyone to go for a fixed rate, they would pity your lack of common sense. Besides, the sales executives of housing loan companies and banks would enthusiastically explain how interest rates had come down. They would also tell you a floating rate loan was a better option since you would benefit if they went down further.
The icing on the cake was the difference between the rate offered for floating and fixed loans by banks and housing loan companies. Floating rate loans for the same amount and same tenure are usually 1-1.5 per cent lower than fixed rate loans.
All these factors made the buyer of the loan go for a floating rate.
As the interest rates started to rise, those who already had already taken a loan did not feel the pinch initially. New loan seekers were still lured by the 1.5 per cent difference in fixed and floating loans, so the party for banks and housing loan companies continued.
As if to soothe customers, banks started increasing the tenure of the housing loan, so that the EMI burden on its clients would not increase. This was again happily lapped up by borrowers, as they felt the rising rates were not pinching their pockets.
What the customer did wrong
Assuming rates would keep going down was the biggest mistake. Opting for more number of years with same EMI was the next one.
A little later in the article, I'll tell you how to look at interest rates. First, I'd like to tell you something about EMI that a layman won't know.
EMI stands for Equated Monthly Installment. It is made up of two components, principal and interest. Thus, every time you pay an EMI, you repay some of your loan and pay interest on the remaining part of it.
In the beginning, the amount you owe the bank/ housing finance company (your loan outstanding) is the highest. Since the interest is charged on the loan outstanding, your interest burden is also at its highest in the beginning. As time progresses, you keep repaying your principal and, hence, the interest burden reduces.
You may wonder why I am talking about this distinction; after all, you are paying the same amount every month. What actually happens is that every time you pay an EMI, its structure has changed internally. In the first EMI, the interest component is the highest and the principal component is the lowest.
As months pass, the interest component starts reducing slowly and principal component of the EMI increases. This can be verified from the split-up, which your lender will give you at the end of the year when you file your tax returns.
Keep in mind that, in the initial years, the principal component may not be enough to cover your tax-saving investment requirement under Sec 80C. You might have to make an additional investment despite taking a housing loan.
Let us try to understand this by way of an example. Assume you have taken a loan of Rs 1 lakh at the rate of 10 per cent for a period of one year. Your EMI will be Rs 8,792. This is what your EMI structure will look like:
|
Months remaining |
Principal outstanding |
Interest paid |
Principal repaid |
|
12 |
Rs 100,000 |
Rs 833.33 |
Rs 7,958 |
|
11 |
Rs 92,042 |
Rs 767.01 |
Rs 8,025 |
|
10 |
Rs 84,017 |
Rs 700.14 |
Rs 8,091 |
|
9 |
Rs 75,926 |
Rs 632.71 |
Rs 8,159 |
|
8 |
Rs 67,767 |
Rs 564.72 |
Rs 8,227 |
|
7 |
Rs 59,540 |
Rs 496.17 |
Rs 8,295 |
|
6 |
Rs 51,245 |
Rs 427.04 |
Rs 8,365 |
|
5 |
Rs 42,880 |
Rs 357.33 |
Rs 8,434 |
|
4 |
Rs 34,446 |
Rs 287.05 |
Rs 8,505 |
|
3 |
Rs 25,941 |
Rs 216.18 |
Rs 8,575 |
|
2 |
Rs 17,366 |
Rs 144.72 |
Rs 8,647 |
|
1 |
Rs 8,719 |
Rs 72.66 |
Rs 8,719 |
If you look at the table above, you will realise that the interest component is at its highest in your first EMI. The difference is more pronounced in the case of a 20-year-loan of Rs 10 lakhs at 10 per cent.
As can be seen in the chart above, even though the EMI remains constant (the yellow band), the components change. The interest component reduces gradually (the blue band) and the principal increases (the pink band).
This means, if you increase the number of years for which you are taking the loan (tenure), you are essentially asking the lender to allow you to keep the money with you for more time. The lender will happily let you do so, because he will be earning interest on that money!
Cut to the present
It has been three years since we saw housing loan rates at seven per cent. Now, they hover around 11 per cent (floating) and 12.5 per cent (fixed) and are always threatening to move up. The finances of floating home loan buyers have been are thrown out of gear. Even after three years, their principal outstanding is not down significantly. They have accepted rising interest rates as a way of life, something they have to live with.
This sentiment is exactly opposite of what it was in 2004. Now they are afraid rates will keep rising. Fear has taken over their minds.
Don't be surprised if, very subtly, the sales executives approach you once again. They would have changed their language now. The last thing you want to hear now is another rate hike (no one can predict it, but it cannot be ruled out either). So these very people, who had advised you to go for a floating rate loan, will now suggest you to convert your floating rate to fixed rate.
The logic they will put forth -- and, under most circumstances, it will be one you will easily buy -- is that the bank or the housing loan company has started a new scheme for the well-being of its clients. Under this scheme, its existing clients will be cushioned from further rate hike. The carrot in this case? There will be no conversion fees if you move from floating to fixed (most loan companies and banks charge a conversion fee from floating rate to fixed home loan rate). This will sound like music to your ears and you may end up making your third biggest mistake!
Beware of these marketing wolves, who are more interested in their targets rather than your well being.
How to read rates
Whatever goes up will always come down; at least, that's what the law of gravity says. Whatever these lending companies do, their objective is simple -- to make profits. There's nothing wrong with that. They are in business and, if they want to make profits, what's the harm?
If anybody is to be blamed, it is the education system which does not emphasise importance of economics.
If you are taking a loan, is it not your duty to keep an eye on things happening around you? You need to keep your eye on the things that will have a material impact on your finances. Lenders will obviously want to charge high interest from you and, if you convert your floating loan to fixed, you would have walked into their trap.
Every Friday, you get to see inflation figures. As inflation rises, central banks will try to cool it by monetary policies. These policies are aimed at sucking money out of the system.
Inflation happens either when there is the supply of goods does not match the demand (which is the case in India right now) or when the supply is more than the demand. Increasing supply is a long-term process, but reducing the supply of money is relatively faster. Hence, as a result of these policies, you see rates being hiked.
As a fallout of hiking rates, consumption cools (people buy less goods because they become costly when interest rates rise) and so does inflation. Then starts the cycle of interest rate cuts.
When rates hiked, it is an indication that, with each hike, we are nearing the peak. However, no one knows when this peak will be reached. Yet, converting your floating rate loan to fixed rate loan at this point may not be the smartest thing to do, especially if you have taken the loan with the sole objective of benefiting from falling rates.
So, for all those who have taken a floating rate home loan, opting for a fixed rate is your individual choice.
What we can give you is the following advice:
1. Try to prepay your loan.
2. Do not increase the tenure for which you are taking the loan.
3. Try to read at least the inflation figure every week (announced every Friday and reported in most newspapers on Saturday) to get some idea of what may happen.
New loan seekers, if possible, wait for some time (economists and analysts have started making loose predictions about rates starting their downward journey sometime in the next 18-24 months). Once rates start going down, we suggest you go for a floating rate loan.
The author runs a Mumbai-based finance advisory Money Bee Investments.
Disclaimer
This article is for information purposes only. Please consult your financial advisor before taking decision based upon this article. Money Bee Investments or any person/s related to the company, directly or indirectly, will not be liable under any circumstances, for losses incurred due to decisions taken on the basis of this article.
