Managing Home Loans in a Rising Interest Rate Scenario

by Gopal Gidwani on July 30, 2011 · 5 comments

in Financial Planning

Introduction
Manish is a 30 year old person working in a private company. Manish’s family includes his wife (homemaker), 3 year old daughter, and retired parents. Manish had taken a home loan of 25 lakhs 1 year back at 8.5% for 20 years with a monthly EMI of Rs. 21696. Apart from repaying the home loan, Manish’s other goals include planning for his daughter’s education, marriage and his own retirement.

Reason for rising interest rates
Since the last one year in its monetary policy announcements the RBI is constantly increasing interest rates (Repo Rate and Reverse Repo Rate) in its battle against the inflation monster. In its latest monetary policy meeting on 26th July 2011, RBI shocked everyone by hiking the repo rate and reverse repo rate by 50 basis points. All this has increased the borrowing costs for banks over a period of time. Initially banks were able to absorb the rate hikes and shield their customers against increased EMI’s. But banks cannot absorb the rising costs of funds all the time. After initially resisting increasing interest rates, banks have now started passing the rate hikes to their customers by increasing the interest rates on floating rate loans. Since the last few months customers have been feeling the pinch of increased rates in the form of higher EMI’s on home loans, auto loans and other loans.

In one year the interest rate on Manish’s home loan has increased from 8.5% to 10%. The EMI has shot up from Rs. 21,696 to Rs. 24,043 and the outstanding balance is Rs. 24.50 lakhs. Against the original total interest outgo of Rs. 13,67,754 now the total interest outgo on the loan in the next 19 years will be Rs. 17,59,484 even after paying the 1st year interest of Rs. 2,08,892.

Just like Manish, lot of other people are facing the same problem due to the increase in their EMI’s. So how can people like Manish tackle such situations? What are the options available to people like Manish?

Pre-payment of Home Loans
Banks allow customers to pre-pay loans. Pre-payment helps the customer to reduce the outstanding amount and thereby reducing the interest burden and also finishing the loan earlier than its normal schedule. Pre-payment can be done in two ways: pre-paying a lumpsum amount at a time or increasing the EMI (5% or 10% or whatever % the customer is comfortable with). Let us explore the two options.

Pre-paying a Lumpsum Amount
If the customer gets a one time cash flow, he can use that to make a lumpsum pre-payment and reduce the outstanding balance on his home loan. For example in case of Manish if he gets an annual bonus from his employer or maturity proceeds from a bank fixed deposit (FD) or National Saving Certificates (NSC) or insurance maturity proceeds then he can use this amount to make a pre-payment and reduce the outstanding amount on his home loan. By making a pre-payment the customer has 2 options:

  1. Reducing the loan tenure: The customer can make a lumpsum pre-payment and reduce the tenure of his home loan and keep the EMI same. Let us see how this will work in Manish’s case. Let us assume that Manish gets a one time cash flow of Rs. 5 lakhs from the maturity of his National Savings Certificates (NSC). If he makes a pre-payment of Rs. 5 lakhs it will reduce his outstanding amount from Rs. 24.50 lakhs to 19.50 lakhs. Manish can ask the bank to keep his EMI same at 24,043 and reduce the tenure of the loan. In such a scenario the tenure of Manish’s loan will reduce from 19 years (228 instalments) to 11 years (136 instalments). Manish’s instalments will get reduced by 92 instalments.
  2. Reducing the EMI: The customer can make a lumpsum pre-payment and reduce the EMI of his home loan and keep the tenure same. Let us see how this will work in Manish’s case. Let us assume that Manish gets a one time cash flow of Rs. 5 lakhs from the maturity of his National Savings Certificates (NSC). If he makes a pre-payment of Rs. 5 lakhs it will reduce his outstanding amount from Rs. 24.50 lakhs to 19.50 lakhs. Manish can ask the bank to reduce the EMI on the loan and keep the tenure same at 19 years. In such a scenario the EMI on Manish’s loan will reduce from Rs. 24,043 to Rs. 19,137 and the tenure of the loan will remain same at 19 years.

Increasing the EMI by 5%
Every individual expects his salary to increase by 5% or 10% every year. So the person can use this increased cash flow to lighten his loan burden. Manish can ask his bank to increase his EMI by 5% compounded every year. In such a scenario Manish’s current EMI will increase from Rs. 24,043 to Rs. 25,245 and subsequently go on further increasing by 5% every year. In such a scenario Manish will be able to repay his remaining outstanding loan amount in 11 years (130 instalments) instead of 19 years. Manish will be able to service his loan in 130 instalments instead of 228 instalments (19 years) and reduce 98 EMI’s.

Some banks do not allow the customer to increase the EMI. In such a scenario Manish can take the difference between the increased EMI (Rs. 25,245) and original EMI (Rs. 24,043) i.e. Rs. 1202 and put it in a monthly recurring deposit. The customer can then use this money to make lumpsum pre-payment at the end of the year. The customer can follow this practice every year till the loan gets over.

Increasing the EMI by 10%
Manish also has the option to increase his EMI by 10%. In such a scenario Manish’s current EMI will incresase from Rs. 24,043 to Rs. 26,447 and subsequently go on further increasing by 10% every year. In such a scenario Manish will be able to repay his remaining outstanding loan amount in 8 years (100 instalments) instead of 19 years. Manish will be able to service his loan in 100 instalments instead of 228 instalments (19 years) and reduce 128 EMI’s.

Some banks do not allow the customer to increase the EMI. In such a scenario Manish can take the difference between the increased EMI (Rs. 26,447) and original EMI (Rs. 24,043) i.e. Rs. 2404 and put it in a monthly recurring deposit. The customer can then use this money to may lumpsum pre-payment at the end of the year. The customer can follow this practice every year till the loan gets over.

Points to Remember:
While the customer can always make a partial lumpsum pre-payment or ask the bank to increase the EMI on his loan there are few things that he should keep in mind. These include:

  • A customer should not use money reserved for other goals like child education, marriage, retirement etc. for pre-payment of home loan.
  • When a customer asks the bank to increase the EMI by 5% or 10% every year then he should make sure that he will be able to service the increased EMI. For example if the customer increases his EMI by 10% compounded every year, then after few years the EMI may become substantially higher and the customer may find it difficult to service it.
  • To make the article simple to explain the article assumes that there will be no further rate hikes in future. But in case of floating rate home loans, the rates may increase or decrease depending on the market direction of interest rates. Once the interest rate changes, all the calculations will change.

Conclusion
So we have seen above how customers like Manish can service their home loan in a better manner. A customer can:

  • Make a partial lumpsum pre-payment and reduce the tenure of the loan and keep the EMI same or
  • Make a partial lumpsum pre-payment and reduce the EMI of the loan and keep the tenure of the loan same or
  • Increase the EMI on the loan by 5% or 10% or any % that he is comfortable with and finish the loan before its normal schedule or
  • Use a combination of partial lumpsum pre-payment and also increase the EMI every year by a certain % and finish the loan before its normal schedule.

The above mentioned all options are very flexible in nature and customers can use them depending on how comfortable they are with each of them.

For any comments please comment in the section below or email us at gopal_gidwani@yahoo.com

{ 5 comments… read them below or add one }

nirmish August 3, 2011 at 8:27 am

good article, but was looking for one information

what is beneficial

increasing the emi by 4K , or putting a lumpsum payment of 48K in start of year.

Reply

Gopal Gidwani August 3, 2011 at 2:44 pm

Hello Nirmish,
Putting a lumpsum payment of Rs 48000 will be more beneficial than increasing the EMI by Rs. 4000.

Let me example with the help of an example. If you have an outstanding loan of Rs. 1,00,000 and you pre-pay Rs. 48,000 lumpsum at the start of the year then your outstanding loan amount will be reduced to Rs. 52,000 and your subsequent EMI will be calculated on Rs. 52,000. So the interest outgo on Rs. 52,000 will be much lower than on the original Rs. 1,00,000.

In the second scenario, if you increase your EMI by Rs. 4000, then your outstanding principal of Rs. 1,00,000 will go on getting reduced slowly every month in proportion to the principal repayment every month. So the outstanding principal will be higher in this scenario than the scenario in which you pay a lumpsum at the start of the year. So the interest outgo in this second scenario will be higher than in the first scenario.

So according to me prepaying a lumpsum amount at start of the year will be more beneficial than increasing the emi. But not everyone has lumpsum amount at the beginning of the year, so in that case the person should go for increase in EMI.

Also regarding your second query on increased EMI. As far as possible a person should increase his EMI every year by say 5% compounded (or whatever % he is comfortable with) with the increase in his annual income.

Reply

nirmish August 3, 2011 at 8:28 am

sorry to add one comment in above qurey, increased emi will be there for one year only.

Reply

dinesh September 13, 2011 at 4:20 am

Due to increse in RAPO rate my EMIs of home loan incresed to 1%. I would like o know is it posssible to keep the EMI same as previous and increse in tenure of my hoam loan even in increse in RAPO rate?

Reply

Gopal Gidwani December 2, 2011 at 7:49 pm

Hello Dinesh,
While deciding whether to increase the EMI or the tenure of the loan the bank takes into consideration the following things: original tenure of the loan, remaining tenure of the loan, current age of the borrower, years left to retire etc. So if the tenure of the loan is less and the bank feels it is manageable limits then when the RBI increase the CRR or Repo Rate or Reverse Repo Rate, then the bank may increase the tenure rather than the EMI. Only when the bank feels that the borrower has reached the maximum tenure that he / she can be offered, then it increases the EMI

Reply

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