As residents in a high-growth, developing economy, we need to be prepared to brace high interest rates from time to time, thanks to inflation! The downside of high interest rates is that loans become more expensive. Now, we all know who bears the major brunt of this. The home owners, of course, because of three reasons: 1) Among individuals, home owners typically take the largest quantum of loan; 2) Among retail loans, home loans have maximum tenure, 20 years on average; 3) Most home loans in India are variable rate loans; even the banks that do offer fixed rate loans build-in a reset clause which allows interest rate on the loan to be increased in the event of a spike in prevailing rates.
If a rise in interest rate is inevitable, the only way to deal with it is to prepare for it, before you purchase your home. Once you make the purchase decision, you will most probably lock yourself into a loan whose repayment is going to consume a good portion of your earning life.
How it works
A commonsense approach to prepare for future increase in your home loan interest rate is to evaluate the worst-case scenario, and then build a margin of safety. If you examine how interest rates have moved over the past decade, you will notice that the maximum level of home loan interest rates during this period was around 14 per cent p.a. So it may be reasonable to assume that the worst-case scenario is home loan rates climbing back to 14 per cent p.a. during the next decade. If it does, you would have two options: make higher EMI payments or settle for extending the tenure of your loan. Although the bank earns more interest income if you choose the latter, for the customer, the former option is any day better. After all, why would you want to pay interest charges to the bank for extra years? And who knows, may be you want to take an early retirement, in which case you would be unable to extend the loan tenure.
The margin of safety question is, can you pay the higher EMI charges if your home loan interest rate increases to 14 per cent p.a. from the current level of 9 per cent p.a.? To know if you can, the first thing you need to do is calculate what would be the EMI amount at 14 per cent p.a. interest rate. Then you need to decide if you can afford this higher EMI level “today”. You may counter my stance as being unnecessarily extra cautious, by arguing that even if an increase in EMI were to occur, it is likely to happen only at some point in the future when your salary would have increased and you may be able to accommodate the EMI increase, if any. I disagree. These days, most couples become home owners at around the time they have their first kid. So even if their salaries increase, family expenses are also likely to increase. It is better to be sure upfront (at the time of purchasing your home) if you can afford a higher EMI in the event of an upward revision in interest rate on your home loan. This would save you from the agony of trying to make both ends meet when the event occurs.
If you are not sure you can meet the higher EMI commitment corresponding to the worst case scenario, it may be better for you to settle for a smaller, less expensive home at the time of purchase. This way you can start with a smaller loan amount and lower EMI, leaving sufficient cushion (margin of safety) for potential increase in EMI at any point in the future.
The following is an example that will help you calculate the maximum loan amount you can “afford” after considering a margin of safety, which will protect you in the event of increase in interest rate.
Let’s say the maximum EMI you can afford is Rs. 30,000. At current market rate of 9 per cent p.a. for variable rate loans, this EMI commitment can make you “eligible” for a 20-year loan of Rs. 33.34 lakhs. You can calculate your loan eligibility in Excel by using the formula PV(interest rate per month, loan period in months, monthly payment). For our example, that would be PV(0.75%, 240, 30000) = 33.34 lakhs.
But a loan for Rs. 33.34 lakhs would leave you with no margin of safety if the interest rates were to rise further. e.g. If the interest rate is reset to 14 per cent p.a immediately after you take the loan (the worst case scenario), your EMI would increase to Rs 41,463 — an amount that you may not be able to afford. (Note: The later the interest rate reset happens during your loan period, the lesser would be your EMI increase. This is because principal outstanding keeps diminishing as your repay the loan.) You too can calculate the EMI pertaining to any interest rate, loan amount and repayment period by using the formula PMT(interest rate per month, remaining loan period in months, principal outstanding on your loan amount)
Eligible vs. affordable
To ensure that your EMI never increases above your target amount (in our example that would be Rs. 30,000) what you need to calculate is NOT how much loan you are “eligible” for, but how much you can “afford”. You can compute your “affordable” loan amount by assuming a worst case interest rate of 14 per cent p.a. (i.e. 1.16 per cent per month) instead of the current market rate of interest of 9 per cent p.a. The formula PV(1.16%, 240, 30000) gives you the loan amount that you can safely and comfortably “afford” — Rs 24.12 lakhs. See how different it is from your “eligible” loan amount of Rs 33.34 lacs! That’s the effect of margin of safety!
Buying a home is a big financial commitment. It’s better to be safe and buy one you can really afford, instead of stretching yourself and facing the risk of Damocles’ sword.
The writer is a finance specialist and consultant. You can reach him on email@example.com or www.shyamscolumn.com