For the last two years, the home loan borrower has been facing the brunt of high interest rates. The Reserve Bank of India has been aggressively using different tools like the repo rate, the cash reserve ratio and the risk weightage on home loans to indicate to banks that their exposure to the real estate sector is too high.
As a result, while some borrowers have suffered a rise in tenure, others are facing an increase in their equated monthly instalments. Of course, the urban borrower, who is often exposed to more than one loan, is facing escalating costs.
For starters, let us look at the impact that the rate hikes have had on the borrower. For the sake of simplicity, let us assume that all the borrowers are paying income tax at the rate 30 per cent and getting the entire tax exemption on interest of Rs 150,000 a year.
At present, the fixed loan rate is 14 per cent per annum, which translates into 10 per cent a year after tax benefits, which remains fixed during the full tenure. Of course, there are clauses in the home loan document that allows the housing finance company or the bank to change the rate, as and when they want to do so.
However, since almost 90 per cent of the home loan borrowers have opted for floating rates, they are facing a rate of around 12 per cent per annum (8.4 per cent after tax benefit) today.
Considering that the average loan size is Rs 10 lakh (20-year loan), the EMI has shot up by Rs 3,258 per month, that is, an additional hit of Rs 39,120 per annum. And that too within a period of two years. In other words, there has been a rise in the EMI by 42 per cent in the last two years over a 20-year tenure. Did someone mention that that the inflation rates have come down to 5.3 per cent?
But the borrowers, who are feeling the pinch are the ones who opted for floating rate or took high fixed rate loans recently. No wonder it is getting reflected in rising defaults, which is up to 3.5 per cent from just 1 per cent in the home loans segment.
So what are the options available to you? One of the options that has been widely discussed is prepayment. However, one should remember that this is directly linked to the nature, risk profile and asset allocation strategy of the borrower. Here are a couple of ways you can prepay:
Excess liquidity: If you have the spare cash to prepay your loan, do it. You can prepay the outstanding loan amount, partly or entirely, instead of investing the surplus in lower-yield investments. It helps in lowering EMIs or keeping them constant while keeping the same tenure.
Remember that banks do not allow an increase in tenure beyond the earning age of 60 years, in case of the salaried and 65 years, in case of the self-employed individual. But this route is mainly for the risk-averse who would invest in safe instruments for low returns.
Exit low-yielding instruments: Another way to prepay is to exit from low-yielding investments like bank fixed deposits, fixed maturity plans, floating-rate mutual funds, monthly income plans etc which yield on an average of 7 per cent after tax.
However, remember that there is no reason to take this recourse of using up your funds earmarked to meet long-term goals like provident fund savings, public provident fund and savings for children to repay the home loans.
However, there are different kinds of borrowers and they have different financial goals. So let us look at the strategy that the different class of borrowers should be following.
Short-term borrowers: If your pending loan tenure is between 6 months to 3 years, try and repay, even up to 100 per cent of the balance amount, liquidity permitting. This is mainly because it is very difficult to take a call on the short-term interest rate movements. However, beware of the cost of prepayment penalty clause in your loan document.
Verdict: Prepay as much as possible
Conservative & risk-averse investors: Pay as much as your liquidity position permits. This is because you have the tendency to invest the surplus mainly into debt market instruments, where the effective yield is lower than the floating interest rate outgo. You can also redeem the existing debt market instruments but excluding (PPF, PF, emergency reserves) to repay the loan.
Verdict: Prepay
Borrowers with aggressive risk-profile: You seek new avenues to improve the overall yield of your portfolios. Hence you look for a minimum return of 15 per cent to 20 per cent per annum by investing your surplus into business, equities, mutual funds, properties and commodities. You should not panic and rush for the repayment as your earnings are higher than the home loan interest cost. Both the EMI and the tenure will go up in the short-run but will even out in the long-run.
Verdict: Continue
High net worth borrowers: Your financial health is good. You look at floating rate loans as a cheaper and additional source of funds, which can be deployed at a much higher rate of return in the greener pastures. You are someone who should be least bothered about a hike in interest rates as you are comfortably placed and well covered for the home loan. For all we know, you have taken the home loan simply to take advantage of the tax benefits.
Verdict: Continue
In short, as we can see there are different kinds of borrowers and depending on your profile, you should take the call on whether to close the loan, partially prepay or continue with the home loan.
The writer is certified financial planner