Home Loan Management in Rising Interest Rate Scenario

Manish is a 30 year old person working in a private company. Manishs 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, Manishs other goals include planning for his daughters education, marriage and his own retirement.

Reason

Since the last one year in its monetary policy announcements the RBI is constantly increasing interest rates (Cash Reserve Ratio (CRR), Repo Rate and Reverse Repo Rate) in its battle against the inflation monster. 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 EMIs. 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 EMIs on home loans, auto loans and other loans. In one year the interest rate on Manishs 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 EMIs. So how can people like Manish tackle such situations? What are the options available to people like Manish?

for

rising

interest

rates

Pre-payment

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 lump sum amount at a time or increasing the EMI (5% or 10% or whatever % the customer is comfortable with). Let us explore the two options.

of

Home

Loans

Pre-paying

If the customer gets a one time cash flow, he can use that to make a lump sum 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 prepayment and reduce the outstanding amount on his home loan. By making a pre-payment the customer has 2 options:

Lump

sum

Amount

Reducing the loan tenure: The customer can make a lump sum pre-payment and reduce the tenure of his home loan and keep the EMI same. Let us see how this will work in Manishs 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 Manishs loan will reduce from 19 years (228 instalments) to 11 years (136 instalments). Manishs instalments will get reduced by 92 instalments. Reducing the EMI: The customer can make a lump sum pre-payment and reduce the EMI of his home loan and keep the tenure same. Let us see how this will work in Manishs 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 Manishs 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 Manishs 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 EMIs. 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. 1,202 and put it in a monthly recurring deposit. The customer can then use this money to make lump sum prepayment at the end of the year. The customer can follow this practice every year till the loan gets over.

Increasing

Manish also has the option to increase his EMI by 10%. In such a scenario Manishs 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 EMIs. Some banks do not allow the customer to increase the EMI. In such a scenario Manish can take the

the

EMI

by

10%

difference between the increased EMI (Rs. 26,447) and original EMI (Rs. 24,043) i.e. Rs. 2,404 and put it in a monthly recurring deposit. The customer can then use this money to may lump sum prepayment at the end of the year. The customer can follow this practice every year till the loan gets over.

Points

While the customer can always make a partial lump sum 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: 1. A customer should not use money reserved for other goals like child education, marriage, retirement etc. for pre-payment of home loan. 2. 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. 3. 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.

to

Remember:

Conclusion
So we have seen above how customers like Manish can service their home loan in a better manner. A customer can: 1. Make a partial lump sum pre-payment and reduce the tenure of the loan and keep the EMI same or 2. Make a partial lump sum pre-payment and reduce the EMI of the loan and keep the tenure of the loan same or 3. 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. 4. Use a combination of partial lump sum 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.