Working on Home Loans

Copyright © 2007
I have been reading articles and hearing a lot about the recent Interest Rate increase
by RBI. Being in the field of finance and having an avid interest, I decided to do my
own analysis.

Taking the first Step:

The trace of Indian economy for the last ten years or so has been a roller coaster ride,
literally. I remember my father paying 18% interest pa on his home loan. The time
was of significant importance for me, because it shaped my financial planning
acumen. I learnt early that the interest rate can change your life.
Then the government intervened. The inflation was down to 4% at one point in time
and the economy was showing all signs of rapid growth – thanks to the IT bubble.
The result – government reduced the interest rates, one quarter after another till the
point where banks were ready to offer a floating rate of 7% on home loans.

Why did the banks keep stating floating rate? Banks were looking at a growing
economy and any person who has studied a bit of macroeconomics would have
forecasted that this would not long last, long enough on a macro scale. If you had
talked to the same banks for a fixed rate, they would say fixed for three years. If you
said fixed for life, they would say not possible, sorry or 10% interest with a clause
that if the interest rate went significantly higher than offered to you, they have a right
to change the interest rate.

What does this mean? This means that people have no escape from the rising interest
rate and the rise is in accordance with the generally accepted principles of
macroeconomics. The rise in inflation followed with the rise in liquidity led to the rise
in interest rates. The more developed countries, however, have different means of
controlling liquidity in market through fixed term bonds, treasury bills, etc. But India
increased the interest rate.

How do the loans work? Before venturing into finding answers to these burning and
important questions, let’s look at how the loans work. We will take an example of
Ram, who wants to own a house in Pune. This is 2002-03 when the home loans were
available at 7.5%. He is now married with a kid of 2 months. Ram and his wife Sita
decide to purchase a house in an area near to his office, a dream house which can
provide for all the needs of Ram and Sita and the little kid. Ram works in a reputed IT
company, and earns Rs 40,000 per month after tax and standard PF deductions. The
couple search for the dream house and find it eventually. The builder is reputed and
the house is of a good quality. The cost is 20,00,000 (20 Lacs), including stamp duty
and utility establishment charges. Ram contacts various funding banks and gets loan
for 92% of the property at 7.5% floating rate for tenure of 20 years.

Here, the 92% of property price is the loan amount against which Ram's property will
get mortgaged. Ram takes advice from his CA and also avails of home loan insurance.
The equated monthly instalment (EMI) calculated for Ram is Rs.14822.91. Adding
1% (assuming) of EMI for basic insurance premium, his total monthly instalment
works out to be Rs.14971.14 rounded up to Rs.14972.00. Ram would be funding the
rest 8% of the cost through his own savings and liquidating some of his investments.

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Working on Home Loans
Copyright © 2007
P *i
The basic formula for working out the EMI =
1
1− n
(1+ i )
where;

Loan = Loan amount, 18,40,000 in Ram's case

i = Monthly interest rate, which is 7.5%/12 = 0.075/12 = 0.00625
n = number of monthly instalments, which is 20 years multiplied by 12 = 240 for
Ram.

Almost all of the home loan funding agencies will use the above formula for
calculating EMI. This method is called the rule of 78ths amortization rule. After the
EMI is fixed and the documents submitted, loan gets approved and the EMI
deductions start from his salary. This is what happens at the bank's end:

All figures in Rupee.

Month Remaining Monthly Insurance EMI Monthly
Principal Interest Principal
Reduction
1 18,40,000 11,500 148.22 14972.00 3323.78
2 18,36,676.22 11,479.23 148.22 14972.00 3323.78
3 18,33,331.67 11,458.32 148.22 14972.00 3323.78

Above, we see what is happening at the bank's loan processing center. Every month
the monthly Interest is calculated (= Remaining principal * monthly interest rate),
fixed insurance is added and the EMI is applied as a payment. The components of
EMI are first applied to Monthly interest and Insurance and the remaining is (say
3323.78 for month 1) is reduced from the remaining principal. This reduced principal
forms the new Remaining principal for the next month's Monthly interest calculation.

200000.00 In the EMI formula, we

180000.00
see that the P and i form
160000.00
a direct relationship
140000.00
with EMI, each rise in
120000.00
the two will definitely
EMI @ 7.5% increase the EMI. The
Rs.

100000.00
EMI @ 12% tenure however has a
80000.00
peculiar relationship
60000.00
with EMI, and that is
40000.00
the inverse of P and i.
20000.00
The graph depicting the
0.00
1 21 41 61 81 101 121 141 161 181 201 221 241
relationship is given
Tenure below, with the tenure
on the X axis and the
EMI on the Y axis.

What can we do? After carefully looking at the EMI vs. Tenure graph, we can
conclude that decreasing the tenure a bit does not affect the EMI much. I went in
further and tried to analyse what is the exact difference it makes. Please take into

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Working on Home Loans
Copyright © 2007
consideration that all these calculations involved simple mathematics and no
discounting was used.

Assuming the interest rates are fixed for life for Ram and he pays the agreed EMI
(14822.91) for the entire life of the loan, i.e., 20 years. Hence the total he has paid
back is 35,57,499.50. However, if he keeps the tenure as 204 months, the EMI will
come out to be 15984.25 and he pays back 32,60,788.00 in total. His savings for the
entire life of loan will be 2,96,712, a saving of 8.34% on a sum of 35 Lacs, compared
to his increase in EMI of 7.83% per month.

Thus the first thing that he could have done was increase his EMI to around 16
thousand (approx) instead of 15 thousand (approx) thus saving a whopping 3 Lacs
(approx).

Second thing which can work well is a lump sum (say 10000 or 20000) pre-payment
at the end of each year and that directly reducing the Remaining Principal and hence
adds a compounding effect to the loan.

Hence, in this case, even if the interest rates rise in future, Ram can keep his EMI
down to 15 or 16 thousand per month and increase the tenure. He can switch the
tenure back to the original once the interest rates fall again.

What about existing EMI payers? The existing EMI payers are left with a few
options when the interest rates rise.
1. They can either keep the tenure same, thus paying an increased EMI till the
interest rates change.
2. They can keep paying the existing EMI, but a two to three year increase in
tenure
3. A combination of above to suit the personal household cash flow
4. Split your home loan with your spouse and avail a lower per person EMI while
also saving tax on both the salaries.
5. Make part repayments whenever your existing investments mature and thus
reduce the EMI keeping the tenure same.
6. Go to the bank and ask for a different loan product and shift your existing loan
balance to the new product. The new products could be:
a. Step up Repayment facility – where the initial monthly payments are
low but they keep increasing at regular intervals, say every year. So
instead of making a fixed EMI for the entire life of the loan, you pay
lower EMI initially and as your salary increases, the EMI also
increases. Currently available with HDFC.
b. Pay only interest for a year or two, till the time the EMI again becomes
manageable – either because of fall of interest rates or because of
increase in salary.

However, when you are engaging in the Step up repayment facility or Only Interest
payment option, please take care that the EMI exceeds the Monthly interest each
month. If this is not so, then you fall to the trap of negative amortization and bad
becomes worse.

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