The recent hike in interest rates has made a lot of home loan customers groan. In the last one year, the interest rates have gone up by as much as 3 per cent. Worst hit are the home loan customers who borrowed at floating rate during the happy days of 2004-5 at rates as low as 7 pre cent.
Banks typically try to keep the EMI fixed while extending the loan tenure. However, extending loan tenure to above 30 years or borrower's potential retirement age (whichever is earlier) is not considered feasible. Instead the EMI starts increasing with interest rate.
Consider the case of Atul and Namita who borrowed Rs 40 lakh for buying their dream home which cost them Rs 50 lakh. They borrowed at 7 per cent floating rate in May 2005. The EMI worked out to Rs 31,000.
They were comfortable paying it from their combined take-home salary of Rs 70,000. In early 2006 the rate hike to 9 per cent had already increased their loan tenure from 20 years to 30 years. When the floating rate further went up to 12 per cent the EMI increased to Rs 41,000 with tenure of 30 years. In the meantime their salaries have risen by a modest 15 per cent -- increasing their take-home income to Rs 80,000.
All of their salary increase has gone in the increased EMI.
What should Atul and Namita do in such a situation? Is it prudent to prepay your loan? Should they 'live with' the hike? Are any drastic measures required or is it a passing phase they need to live through?
The answers differ from case to case. Like any other personal finance question, this one needs to be answered after taking into account several factors and drawing a robust financial plan. What we offer below are some starting points for your thinking.
How much are my liquid assets and how much are they earning me?
If you have sufficient liquid funds, you need to ascertain how much you are getting as returns on your funds -- and ensure that this is more than the cost of home loan. Simply put, in today's scenario, your financial assets need to earn at least ~10-12 per cent, post-tax.
If you are not comfortable with building a portfolio aggressive enough to generate these returns, you are better off using most of the liquid funds in prepaying the costly loan. If your funds are idling in saving bank accounts, this is a no-brainer anyway.
While you do need to maintain contingency reserves as well, typically amount equivalent to 6 months' expenses should suffice for that. Rest should be either deployed in high return avenues or prepayment of the loan.
Is there a fundamental mismatch between in my income and the EMI paying capacity?
Many banks have given home loans to borrowers at their full borrowing capacity. This means, at a take-home income of Rs 40,000 you could service a maximum loan of Rs 20 lakh. The catch, of course, is the interest rate at which you could afford to pay for the loan.
When interest rates rise from 7-8 per cent to 12-13 per cent, your EMI increases by as much as 40 per cent. When such increases happen in a short period of time (such as during 2005-2007), income growth typically does not keep pace. The right question to ask is -- given the new EMI and my income (current and projected in next five years), am I going to be comfortable paying the EMI? If not, you need to evaluate your finances carefully -- as mentioned in points 3 and 4 below.
What is the EMI increase eating into? Can I cut down on the expenditure?
Some families borrow within their means and thus even after paying the EMI, have a healthy savings rate of 20-30 per cent of income. For them, the pinch is less painful -- lower savings and some cut-down on expenditure. However, many families, in the heydays of low interest rates, had gone for their "dream house" often stretching themselves in the process.
Not only do they pay as high as 40 per cent of their take home income as EMI, they also have fairly low savings rate. Such families are worst hit by interest rate rise since they have no choice but to cut down on expenditure and thus lifestyle when EMIs increase. In such circumstances, it is advisable to evaluate measures to cut down on other costs -- e.g. settling the car loan if any by selling off the car, less frequent eating out, smaller mobile bills, avoiding impulsive shopping and fewer vacations.
One question remains -- are you taking short term measures for a long term issue? If your home owning cost has fundamentally become gone beyond your means, it is worth reevaluating the entire decision.
Going back to drawing board -- should I sell the house?
A temporary increase in EMI can be tolerated if it is indeed temporary. Taking a hit on the lifestyle or savings rate or both in the long run only to own a home can be financially sub-optimal. While emotions are above financial matters, there are times when the financial issue is much too critical to ignore.
Some pointers on evaluation of your home purchase decision -- consider your income three years hence. All your EMIs together should not exceed 30 per cent of it.
If there are major cost additions expected (e.g. children's education), use a lower limit of 20 per cent. If EMIs exceed this proportion, it may be prudent to sell the property and settle the loan. Using the proceeds, you can eventually buy a less costly house -- preferably after a period of 1-2 years.
To summarise
- Ensure that you use your liquid assets to prepay the loan (or earn returns higher than interest rate on the loan).
- If your liquid assets are not sufficient, try to cut down on other expenses like car loan EMI, discretionary expenses, etc.
- If your income-expense projections indicate the EMI burden is going to be unbearable beyond the short term, sell the property and settle the loan.
1 lakh = 100,000
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The author is Director (Real Estate & Loans), PARK Financial Advisors Pvt Ltd, Mumbai. He is an IIM Ahmedabad alumnus. He can be reached at info@parkfa.com
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