Risk planning before borrowing a home loan:
Borrowing a home loan is one of the important financial decisions in an individual’s life. Managing financial resources after taking a home loan could be as taxing as hunting for a value-for-money property. The obvious risks involved in taking up a home loan liability include sale of house by bank in the event of the borrower’s death or loan default, rise in interest rates, decrease in repayment capacity due to loss of job or other unforeseen factors. Proper risk planning will enable a home loan borrower to take care of the EMI payments and also to manage other financial goals. This includes:
1. Reserve emergency funds: Payment for a property purchase includes some amount of home loan and the balance as down payment from a borrower’s own funds. Making a down payment for a house is one of the events which usually entail a big cash outflow from an individual’s savings. The borrower should make sure he does not hit rock-bottom in his savings post the property transaction. Contingency funds (preferably six month expenses) will help a borrower tide over unexpected circumstances like a medical emergency or loss of job.
2.Assess EMI affordability: Before taking a loan, a borrower should assess how much monthly instalment he can afford to pay from his net take-home salary apart from meeting his household & personal expenses. Additional expenses in the new home in the immediate term like interior decoration, painting and furniture need to be discounted. Further, maintenance expenses in a new building will be higher compared to an old building. There are instances where many families decide to stay separate from their dependant parents after buying a new flat and maintain two homes. In such cases, household expenses are likely to be on the higher side. All these factors need to be discounted while assessing the EMI capacity.
3. Study EMI structure: A borrower should know the EMI break-up as it will help him take prepayment decisions and also decide upon the tenure of the loan. The EMI payment of a loan has a principal and interest portion.
Many people are not aware that in the initial years of repaying loan, interest component is very high compared to principal repayment. For instance, suppose Mr.A borrows a home loan of Rs.45 lakhs for tenure of 20 years at an interest rate of 10.75 per cent per annum from SBI. The EMI comes to Rs.45,686. In the first EMI, i.e, Rs.40313, 88 per cent of the instalment goes towards interest payment while the rest goes in principal. Effectively, the loan will be reduced by just Rs.5,373 in the first month and Rs.67,749 in the first year. Similarly, for the first five years of the loan, the total interest charges come to a whopping Rs.23,16,741, which is 51 per cent of the loan amount. This is assuming Mr.A did not repay any amount during this period. The principal amount at the end of five years would have reduced by just Rs.4,24,419, which is 9.4 per cent of the original loan amount.
It thus becomes crucial to prepay small chunks every month or quarter in the initial years which will reduce the outstanding amount. Now that the RBI has removed the prepayment penalty charges, a borrower can repay as much as he wants at any time of the year.
4. Deciding on the tenure of the loan: The monthly instalment for a loan with a longer tenure will be smaller than the one with a shorter tenure. Many a times, borrowers opt for longer tenure loans thinking that they will repay the loan in 5-6 years and pay less EMI. However, it is important to note that a borrower pays more interest on a loan with a longer tenure or a bigger principal. For instance, Mr.B borrows a loan of Rs.45,00,000 from SBI at 10.75 per cent per annum and prepays the loan at the end of 8 years itself. If he opts for a 20 year loan, he will end up paying Rs.35,73,686 as interest over the 8 years whereas the interest will be Rs. 33,11,290 for a 15 year loan. Effectively, he ends up paying Rs.2,62000 higher interest if he goes for a longer tenure loan.
5. Compare home loan packages across banks: It is prudent to pick 3-4 banks of choice and enquire about home loan packages. A borrower can prepare a questionnaire before making home loan enquiries with bank staff regarding eligibility for home loan, interest rates, tenure of the loan, period for approval & sanction of home loan, reasons for home loan rejections, mortgage & property insurance and incentives available (e.g,waiver of EMI, moratorium period in case of loss of job). While considering different loan packages of banks, a borrower should compare their repayment schedules and the total interest payable over the tenure of the loan. While the EMI calculation will be the same as per formula, the interest portion charged by different banks in the initial years of the loan may vary. A borrower should also enquire about teaser packages where promotional rates or fixed rates are offered in the initial years.
6. Buy insurance to cover home loan risk: A house is in the borrower’s name only after he repays the full loan amount. In the event of the borrower’s death during the interim loan period, his family can face eviction from the house if they could not afford to pay EMIs. Buying life insurance will help a family pay off the outstanding loan amount in the event of borrower’s death. Term loan insurance is a cheaper and better option compared to home loan protection packages offered by banks. A pure term insurance cover will remain constant for the entire tenure of the loan and will offer a fixed benefit in an unfortunate event. Home loan insurance on the other hand will offer reduced benefit which is in proportion to the outstanding loan amount. Also, an insurance contract bought from a bank may turn void in case a borrower switches to another bank. A new cover will be required to purchase from another lender.
7. Pay off your home loan as soon as possible: There have been many debates about whether it is beneficial to continue home loan or prepay them at regular intervals. The usual argument here is if a borrower gets returns which are better than the interest rate of the home loan, he should invest his savings rather than utilise them in prepayment of loan. Considering the volatility in interest rates, a borrower needs to take into picture the whole tenure of the loan rather than few years where floating interest rates have been lower than investment returns. For instance, in 2009, interest rates were in the range of 8-9 per cent and equity markets were yielding returns of at least 25-30 per cent. Presently, interest rates are hovering around 10-11 per cent and equity markets are yielding poor returns or in the negative. By the time, a borrower decides to prepay his loan because of the increased burden, the bank would have recovered a major portion of his interest. Keeping a periodic target and clearing off the loan is thus prudent. Prepaying the loan and receiving legal possession of the house will offer peace of mind to borrower compared to the loan liability hanging over his head.
5. Compare home loan packages across banks: It is prudent to pick 3-4 banks of choice and enquire about home loan packages. A borrower can prepare a questionnaire before making home loan enquiries with bank staff regarding eligibility for home loan, interest rates, tenure of the loan, period for approval & sanction of home loan, reasons for home loan rejections, mortgage & property insurance and incentives available (e.g,waiver of EMI, moratorium period in case of loss of job). While considering different loan packages of banks, a borrower should compare their repayment schedules and the total interest payable over the tenure of the loan. While the EMI calculation will be the same as per formula, the interest portion charged by different banks in the initial years of the loan may vary. A borrower should also enquire about teaser packages where promotional rates or fixed rates are offered in the initial years.
6. Buy insurance to cover home loan risk: A house is in the borrower’s name only after he repays the full loan amount. In the event of the borrower’s death during the interim loan period, his family can face eviction from the house if they could not afford to pay EMIs. Buying life insurance will help a family pay off the outstanding loan amount in the event of borrower’s death. Term loan insurance is a cheaper and better option compared to home loan protection packages offered by banks. A pure term insurance cover will remain constant for the entire tenure of the loan and will offer a fixed benefit in an unfortunate event. Home loan insurance on the other hand will offer reduced benefit which is in proportion to the outstanding loan amount. Also, an insurance contract bought from a bank may turn void in case a borrower switches to another bank. A new cover will be required to purchase from another lender.
7. Pay off your home loan as soon as possible: There have been many debates about whether it is beneficial to continue home loan or prepay them at regular intervals. The usual argument here is if a borrower gets returns which are better than the interest rate of the home loan, he should invest his savings rather than utilise them in prepayment of loan. Considering the volatility in interest rates, a borrower needs to take into picture the whole tenure of the loan rather than few years where floating interest rates have been lower than investment returns. For instance, in 2009, interest rates were in the range of 8-9 per cent and equity markets were yielding returns of at least 25-30 per cent. Presently, interest rates are hovering around 10-11 per cent and equity markets are yielding poor returns or in the negative. By the time, a borrower decides to prepay his loan because of the increased burden, the bank would have recovered a major portion of his interest. Keeping a periodic target and clearing off the loan is thus prudent. Prepaying the loan and receiving legal possession of the house will offer peace of mind to borrower compared to the loan liability hanging over his head.
