Be home-loan wise in a slump

Declining interest rates and property price discounts could well be a blessing for those looking forward to owning a home. However, a slowing economy, pay cuts and fear of job losses appear to offset the positives. Added to this, inflation at 2.4 per cent (close to June 2002 levels) threatens to drag the economy down further.

In the current situation, buyers may have to take a conservative approach when going for a home loan. Existing borrowers can re-look at prepaying loans in advanced stages, though the lower interest rates may seem to make a case for staying on. Others, bogged down by pay cuts or job losses, may seek a way out with their bankers. Here are a few tips on how future and current borrowers can make the best of the current financial environment.

New borrowers


Do not go overboard. While you can thank your lucky stars if you are in a job that is relatively stable, it is perhaps wiser to err on the side of caution when it comes to borrowing in these tough times.

When you seek a new home loan, remember that your real ability to repay the loan may not be the same as what the banker assumes it to be. A bank typically assumes the percentage of your income available to service debt (based on the bank’s own experience and the available data on spending patterns) on the basis of which it will determine your loan eligibility.

For instance, for a Rs 10 lakh loan at 9.25 per cent interest for 10 years, the equated monthly instalment (EMI) works out to Rs 12,800 a month. If the bank assumes that about 40 per cent of your monthly income, of say Rs 40,000, is available to pay EMIs, Rs 16,000 would be the money disposable towards the EMI. Based on this assumption, your loan eligibility would be (16000/12800) x 1000000, which is Rs 12.5 lakh. In other words, you are eligible for an amount higher than the Rs 10 lakh that you wanted.

In case more aggressive assumptions are made, the eligibility may be much higher. Such a calculation should not misguide buyers into believing that they can go for a property of higher value, unless they are willing to plough in more of their own capital.

Remember, the surplus that you generate every month may turn out to be as low as 20 per cent (Rs 8,000 a month in this example), after various commitments that your banker may not be aware of. In such a case, you may have to end up draining your savings to meet the EMI or request for a longer tenure.

But what are the expenses/incomes one should consider for arriving at disposable income? Apart from your regular monthly expenses, provide adequately for contingencies such as medical expenses. Your savings commitments such as SIPs, if you are already running one, should also not be heavily compromised. Loan repayment should not hinder your long-term wealth building plan.

Besides, if you favour prudence, do not add your variable pay package to calculate your disposable income; some companies tend to spread the variable pay across the 12 months. You can always accumulate such sums to prepay a part of your loan periodically.

As far as possible, factor in a disposable income not exceeding 30 per cent of the income, even in case of double income families. This way, any temporary out-of-job situation of a spouse may not provide much reason for alarm.

Avoid galloping EMI. Banks offer home loan schemes that would allow you to step-up your repayments (EMIs) based on the expected increase in your income.

Such schemes are offered with an intention of qualifying an individual for a higher loan/property value. This would essentially require the bank to make an assumption on your pay hikes. So in year three, you may be paying an EMI higher than year one. Banks may well assume a past pay hike of say 5-15 per cent to be your future increase in income.

In an economic downturn such as the present one, this equation could well convert into a 5-15 per cent decline in pay. So beware. Go for a fixed EMI and avoid ambitious schemes.

Bear in mind that in the long term your repayment tenure/EMIs could well rise due to higher interest rates. In those times, any surplus would come in handy.

Existing borrowers


If you own a home and a bulky loan, you may have to take a re-look at your liability and your ability to repay on a periodic basis.

The brighter side of an economic downturn is that it provides an opportunity to reduce liabilities. A slowing economy also provides stable income-earners an opportunity to prepay at least a part of their loan. Two factors will determine this:one, the surplus available in hand; two, the net interest cost of loan versus investment opportunity by parking the surplus elsewhere.

If you have accumulated a reasonable sum as surplus and plan to invest it at a time when interest rates are falling, chances are that you will get low yield on such investments.

Take an example: A bank deposit with, say, an interest rate of 8 per cent would provide a 5.6 per cent yield net of tax (assuming a 30 per cent tax bracket). At the same time if you have been servicing a home loan of say 9.75 per cent, the net cost after tax benefits comes to 6.8 per cent. It makes economic sense to pay a high-cost debt instead of locking money in a low-yielding FD.

But why prepay now, during an economic downturn, when the floating rate of your loan may actually become lower? This is simply because of the lack of alternative opportunity to park your surplus and also the widening gap between interest rates and inflation. In other words, in makes sense to prepay during a time when inflation is declining at a pace higher then the falling interest rates.

However, ensure that you have paid your other loan commitments such as credit card, auto or personal loans before prepaying home loan. Remember the latter enjoys tax benefits on repayments, while the other loans do not.

Also note that it may not be wise to prepay early on in to your borrowing years especially when you decide to repay in full. For one, the prepayment charges are higher in the initial years, two, given the high interest component in the EMI in the initial years, the tax benefits enjoyed are quite substantial.

Struggling to repay?


Talking of prepayment, what about those who have received pay cuts or lost jobs? Here are a couple of options for you. Approach your bank and ask for a solution. If you have had a clean record of repayment, the bank may consider a reduction in EMI and prolong the tenure.

Alternatively, if you hold an investment that is earning a low interest (do the calculation suggested above for prepayment), do not hesitate to break it and prepay a part of the loan and settle for a lower EMI instead.

Check with your bank on the consequences of a couple of months of default and keep the banker posted on other job options that you have considered/received. The idea here is provide some comfort to your banker as to your ability to meet your commitments.

All said, for those who have invested in the boom phase and are seeing their first downturn now, you would emerge more money-wise and prudent at the end of this.