Buying a home? Choose your interest rate!

here are two ways of looking at interest. The nice way is where you are paid.

The not-so-nice one is where you pay!

This article is about the latter.

More specifically, it is about when you buy your home and shrewdly make a finance company/ bank pay for it.

Remember, you are actually buying more than your home. You are buying into your lender's interest rate. Which means you are not only going to pay for your home; you will also thank the lender by paying him for the money he is giving you. 

In such a scenario, if you take an Adjustable Rate Loan (known as a Floating Rate Loan), what happens when your interest rate changes constantly? It could be financial mayhem!

Here's a look at the logistics of such a loan.

PS: This article is about rising interest rates. Those are the ones we should worry about! To understand the link between inflation and interest rates, and how it affects a borrower and investor, read Where is your money going?

What's an Adjustable Rate Loan?

Adjustable Rate Home Loans are the ones in which the interest rates change throughout the duration of your home loan. This means you will have no clue or information in advance as to how your rate will move!

There are three questions that come to the borrower's mind.

1. When will the interest rate change?

Your rate will change at a fixed period of time. This will be specified when you sign the loan contract. Typically, it happens every quarter -- once in three months -- and will be referred to as the Review Date.

Review dates are specific to the product.

Lenders like ICICI Bank have set review dates for all adjustable loans, like January 1, April 1, etc (the first day of every quarter, starting January).

HDFC has set it for every quarter from the date of your disbursement (the day you walked in and collected your cheque). Therefore, each loan has a different review date.

2. How will the interest rate change?

It does not change, depending on whether or not someone in your home finance company is having a great day.

Your rate will be based on a base rate. A base rate is a pre-selected, internal rate of the lender. If the base rate changes due to changes in the interest rates in the ecnonomy, your rate will be affected.

This base rate typically varies from lender to lender, and so does their nomenclature. 

HDFC calls it the RPLR -- Retail Prime Lending Rate.

ICICI Bank uses the term FRR -- Floating Rate Reference.

3. By how much will the interest rate change?

As mentioned earlier, the base rate is obviously responsive to changes in the economy.

As interest rates in the economy move, so does the base rate. To this rate, the home finance company will attach what is called a Spread or a Margin.

A spread is the percentage added or subtracted from the base rate. This is meant to cover the lender's administrative and miscellaneous costs!

Now, the base rate will rise and fall over the life of your loan, but the margin usually remains constant.

Let's say HDFC's RPLR was 9.75%. The interest rate offered to you could be RPLR -- 1% or PLR + 0.5%.

So you could either get it higher (premium) or lower (discount) than the base rate.

Hence your actual Floating Entry Rate = RPLR +/- SPREAD

Here is an example

Loan amount = Rs 10 lakh

Tenure = 10 years (120 months)

June 1, 2004

The lender's base rate = 9.75%

Margin = Base rate – 1%

Your entry floating rate = 8.75%

August 1, 2004

The lender increases the base rate by 0.5% to 10.25%

Your review date: September 1, 2004

The lender's base rate now = 10.25%

Margin = Base rate – 1%

Your present floating rate = 9.25%

If you keep your EMI constant at Rs 12,533, your loan term has just increased by five months.

If you choose to exercise the other option, of keeping your tenure the same and increasing the EMI, your revised outflow at the increased rate of 9.25% would be Rs 12,798 vis-a-vis the Rs 12,533 you enjoyed the last quarter!

How is this different from a fixed rate home loan?

Very. The difference lies in how the rates are set and move. In a fixed rate loan, the interest rate remains constant over the life of the loan.

So if your 10-year loan is for 8% per annum, it stays like that for the next 10 years. 

So you get predictability. Your monthly payment to the home loan company (EMI) stays the same. So does your repayment tenure. No unpleasant surprises.

You got it! Financial certainty for your wallet.

Scenario Building

I wish we knew what future interest rates will be, but the brutal truth is we don't. And, most probably, never will.

So, if you take a fixed rate loan at a low interest rate, the rising interest rates won't bother you. In fact, your lender will have to deal with that problem. He is paying the price for the increase in interest rates, not you. This is debt Utopia!

Sounds cruel? Not really. Forewarned is forearmed!

Oh no! I took an adjustable rate loan!

Blame it on the office cafeteria -- the place which breeds financial awareness and knowledge. It was over Aloo Paratha that you were convinced that interest rates are meant to go downward.

And, a few sessions of serious brainstorming with your buddies over numerous spreadsheets made you hop on to the floating rate bandwagon.

Just one teeny weenie error. You forgot to factor in the explosion of crude oil prices in the year 2007. (But how in the world were you to know that anyway!)

The impact on your loan -- there soars your interest rate!

Relax. There is a lot in your favour too.

Due to the possibility that rates may rise, there are two attractive features. Floating rate loans are cheaper than fixed rate loans when applying for a loan. Also, there is no prepayment clause.

Visualise the rates going downhill. That is the best thing that could happen to your wallet. Can you imagine the glee of reclining in your favourite chair, watching the rates slide!

The option to convert

Yes. You can switch loyalties. If the going gets tough, you can convert into a fixed rate product.

Just one small nugget: At a cost. Typically, the converted fixed rate is usually higher.

So go ahead and ask them about the costs involved if you decide to exercise this option in the future.

HDFC and ICICI Bank charge fees to the tune of 1.75% of the outstanding loan amount for conversion.

Also, find out how often you can switch loyalities. They won't permit you to switch every single month.

So much for the unveiling of the adjustable rate loan.

Today, as a prospective home loan borrower, you have more financing options than ever before. Your needs boil down to finding a loan that suits your present and future finances.

For that, you must indulge in preliminary information-gathering activity. 

Please remember an inappropriate choice of a loan will result in far more dire consequences than just lack of sleep.

DON'T MISS!
• Make sure you get that housing loan
• Buying a house? What loan should you take?
• What are the current home loan rates?
• How to qualify for a home loan
• How to pay for your new home
• Should you rent or buy a home?

Illustration: Dominic Xavier