The home loan industry has never looked healthier. With real estate experiencing a boom, prices are heading northwards. Housing finance companies (HFCs) are falling head over heels to woo the borrower with value added services and flexible products.
The step-up loan is one such product, which offers the much-needed flexibility to the borrower. But what is it and how does it work?
A step-up loan is a kind of home loan, which offers varying equated monthly installments (EMIs) spread over the loan's tenure. For example, the EMI is lower in the initial years and as time rolls by, the EMI increases.
An illustration will help in understanding things better.
Home loan from ABC Housing Finance Company Ltd.
| Loan amt. (Rs) | Term (Yrs) | Interest rate (%) |
EMI for initial 2 yrs (Rs) |
EMI for remaining 18 yrs (Rs) |
| 1,000,000 | 20 | 7.51 | 6,560 | 8,390 |
In the table, the amount of loan taken is worth Rs 10 lakh (Rs 1 million) for 20 years. The interest charged on the loan is 7.51 per cent. The EMI works out to Rs 6,560 for the first 2 years. For the remaining tenure, i.e. 18 years, the EMI is Rs 8,390.
It is evident that the HFC has given the flexibility of a lower EMI to the borrower who may not be in a position to pay a higher EMI in the initial years of the loan.
The step-up loan has got various advantages.
One of the primary advantages of a step-up loan as compared to a normal home loan is that it increases the loan eligibility of the individual. Since this loan takes into account the future earning potential of the prospective borrower, it factors in the imminent hike in the earnings going forward and adjusts the loan eligibility amount accordingly.
For example, an individual earning Rs 20,000 per month will be eligible for approximately Rs 13.64 lakh (Rs 1.364 million) with a 20-year tenure under a normal home loan from a certain HFC. But the same individual will be eligible for approximately Rs 14.79 lakh (Rs 1.479 million) under a step-up loan from the same HFC. That's a difference of Rs 115,000.
It is useful for individuals who are earning a lower income in the initial years of their careers. For example, MBAs/CAs who have just embarked on their careers are good candidates for such loans. Typically, they are earning a 'lower' salary as they have just begun their careers. But their salaries have a very good chance of going northwards in good measure in due course.
Such individuals can also contemplate buying a residence for themselves instead of staying on rent. The issue of rent versus buy might crop up due to affordability concerns. Individuals might not be in a position to purchase a house outright.
The step-up EMI will help solve this apprehension. Why pay rent when the same money can go towards buying a house and in effect creating an asset for yourself?
So does that mean that step up loans are the way to go for most individuals? Not always. Let us take a look at the probable shortcomings of a step-up loan.
The one big truth with a step-up is that it increases the net cash outflow for the borrower.
An example will help in better understanding this statement.
Step-up EMI versus normal home loan EMI
| Loan amt (Rs) | Term (Yrs) | Interest rate (%) | Net outflow over 20 yrs (Rs) | |
| Step-up loan | 1,000,000 | 20 | 7.51 | 1,969,680 |
| Normal Loan | 1,000,000 | 20 | 7.51 | 1,935,120 |
| Net EMI difference | 34,560 | |||
As can be seen from the table, the net cash outflow under a step-up loan over a 20-year period amounts to Rs 1,969,680. Whereas, if an individual were to opt for a normal home loan, his net cash outflow over the same period would be Rs 1,935,120. The net difference over 20 years amounts to Rs 34,560.
It might be argued that the individual has actually paid a lower EMI in the initial two years and only then has he moved on to pay higher EMIs compared to the normal home loan EMI. That argument is taken. But even then, quick back-of-the-envelope calculations show us that the step-up EMI proves to be costlier in the long run.
Step-up loans are also generally available only to salaried individuals and professionals. In other words, businessmen cannot take advantage of this type of loan. This is because the general feeling amongst most HFCs is that salaries have a tendency to rise year on year. This is not always the case with businesses, which may be doing well at a given point in time but are generally conceived to be unpredictable in nature.
Step-up loans usually have a minimum loan amount. For example, a certain HFC, ABC Ltd, may have a floor amount of Rs 800,000. Individuals who want to borrow a lesser amount may not be in a position to take advantage of this loan.
So how do step-up loans fare compared to normal home loans?
The call on whether step loans are better or a normal home loan depends on individual requirements. There are various products designed to meet the varying requirements of individuals and you need to select the one that best suits you.
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