The burden of borrowed money

The burden of borrowed money
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First Published: Wed, Jun 27 2007. 11 41 PM IST
Updated: Wed, Jun 27 2007. 11 41 PM IST
Spending sleepless nights trying to figure out how to juggle all your loan-repayment schedules? Worried about getting a call from a loan officer over a delayed or defaulted payment? Living on borrowed time?
“Many people don’t even realize that they are taking up an additional liability when they opt for a loan. It’s only later when they read the fine print or realize that the interest cost is pinching them hard that they start regretting their decision,” says Gaurav Mashruwala, a Mumbai-based financial planner.
Even if you didn’t think twice before saying yes to the sweet-talking bank executive who sold you a “pre-approved” loan at the most “attractive rate”, or before adding that new gold credit card, don’t lose hope. Here are some tips to keep in mind the next time you are considering a loan.
More than anything else, the steep rise in home loan interest rates has thrown many financial plans out of gear. From about 7.5% in October 2004, interest rates now hover around a hefty 12%.
Despite this, home loans are certainly better than personal or credit card loans as the value of property is likely to appreciate given the supply and demand gaps in India. Plus, you are also living in the house and enjoying its comforts now and will do so well after the loan is repaid. Also, a home loan qualifies for tax benefits of up to Rs1,00,000 on the principal amount repaid and up to Rs1,50,000 on the interest paid. “After factoring in just the tax benefits, the effective interest rate on home loans works out to 6.1% on an interest rate charged at 11.25%, assuming all the tax benefits have been availed of,” says Mahesh Shah, spokesperson, HDFC Bank Ltd.
Points To Ponder
Cash inflow: This should be the bottom line before you take any loan. Financial planners advise that loan repayment amounts ideally should not be more than 35-40% of take-home income. Even if you have a long-tenure home loan, the total repayments should not exceed 25% of take-home income.
Prepayment charges: Always confirm this clause with your agent. Some banks charge you a penalty of around 2% if you want to close the loan with a lump-sum payment, especially in a rising interest rate environment.
Loan tenure: Ask your agent if you can increase your equated monthly instalments (EMIs) in proportion to an increase in your income. For instance, if you increase your EMI by 10% annually for a 15-year loan, you should be able to close the loan in about eight years. Confirm the bank’s policy on increasing or decreasing your loan’s tenure as well. Typically, you can increase your loan tenure provided it doesn’t go beyond your retirement age.
Statutory charges: If you haven’t already paid any statutory charges to your bank for the property, you may be asked to do so any time. These could include stamp duty, interest charges and penalty.
Processing fees:Check the bank’s processing fee—it is usually around 0.5% to 1%. You may also have to pay lawyers who scrutinize your property on behalf of the bank to ensure there are no third-party claims.
Identify the property:Some banks sanction a loan before identifying the property. It may lead to problems at a later stage if the bank raises an issue with the age of the property or if it is being developed by a relatively unknown builder.
Fixed vs floating: Interest rate cycles are very unpredictable, and, ideally, this decision should be based on your financial condition. If slight hikes in interest rates can push you into a debt spiral, a fixed rate of interest is a better option. But before deciding, look at the bank’s history with interest rates. “A fixed rate suggests that it would remain the same during the tenure of the loan. It should be clearly stated in your document that rates will remain fixed. However, with the fluctuations in the market, most banks changed their rates, throwing the customers’ calculations completely awry,” says Harsh Roongta, chief executive officer,, a website which advises on loans and credit cards. Some banks, such as HDFC, have also come up with a two-in-one home-loan scheme where a borrower can divide the loan into both fixed and floating rates.
A personal loan is just a phone call away nowadays. All you need is a relationship with the bank for a certain period of time, a minimum savings balance and a good repayment track record of other loans. These days, most banks don’t even ask you for a guarantor. But this money comes with a big price tag. Interest on personal loans varies from 15% to 40% per annum, depending on the loan amount and your haggling skills. Says Mumbai-based financial planner, Archana Bhingarde, “Usually, we don’t explore all possible sources for our loan and then repent for paying high interest rates. With interest rates going up, it is time to swap all high-cost loans with low-cost ones. For instance, many people don’t know that a loan against a life insurance policy, especially from LIC, comes at a much cheaper rate compared with those from private sector banks.”
Points to Ponder
Administrative and processing charges: Simply comparing EMIs and interest rates of different banks is not enough. Do find out if there will be any administrative charges, and if so, how these will be levied. This is important because the final loan amount disbursed could be net of these charges, but the EMI may be calculated on the full loan amount. For instance, if a Rs1,00,000 loan bears a service charge of Rs2,000, the actual loan amount disbursed to you would be Rs98,000 and the monthly instalment may be calculated on Rs1,00,000. Also, most banks charge a processing fee of between 0.5% and 1%, with some even charging 2%. These are negotiable expenses and one needs to haggle with banks to try and avoid or minimize these.
Advance EMIs: Some banks may ask you to prepay the last one, two or three EMIs at the time of taking the loan. Assuming that the loan amount is Rs1,00,000 and the EMI works out to Rs5,000 per month for a two-year tenure, you may have to pay a two-month advance EMI of Rs10,000. Effectively, the tenure of your loan is 22 months, but your interest component, which is part of the EMI, is being calculated for 24 months. Therefore, if the loan document has a clause on a default advance EMI option, it is advisable not to opt for it.
If you are one of those who never manage to pay your credit card bills on time, it is time to wake up. Interest rates on credit cards are perhaps the highest: 2.25-2.95% per month even if you are taken in by reward points, which usually encourage you to spend more and don’t necessarily add up to a lot in terms of their monetary value.
Points to Ponder
Billing cycle: You can reduce your interest expenses considerably if you use your billing cycle properly. Suppose your billing date falls on the 28th of every month and you use the card on the 29th, you get a grace period of a month as you will only be billed in the next cycle.
Balance transfer option: Many banks give you an option to transfer your balance on their card with certain months of interest-free period. By doing this, you can save on interest expenses. “Recently, I transferred my Citibank credit card balance of Rs20,000 to a State Bank of India card, where I only had to pay Rs200 for a three-month, interest-free period. After the calculations, the interest I paid was effectively 4% per annum,” says Gaurav Gupta, a 26-year-old design engineer at Rambus Chip Technologies India Pvt. Ltd.
Minimum amount due: Don’t fall prey to it. When you carry a balance from month to month, most banks charge you an interest on the total amount rather than on the outstanding balance. Some don’t even give you a grace period on new purchases.
Card limit:You would be wrong if you think the bank will block payments once the credit card limit exceeds. Banks simply charge a hefty penalty of 5% on the exceeded amount. You might, therefore, want to always remember your credit card limit.
Cancelling the cards: It is not enough to tear up your card into pieces. You need to pay all the outstanding bills and communicate it in writing to your bank. Sometimes, the most recent transaction is not covered in your latest bill and charged in the next month’s bill. Therefore, before the cancellation, make sure there are no charges even in the next month’s bill.
“When you can’t avoid taking loans, the best way is to learn the art of loan management,” says Sapna Narang, partner at Capital League, a Gurgaon-based wealth management firm. “Most people panic at number crunching, but all it takes is simple mathematics.” And common sense.
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First Published: Wed, Jun 27 2007. 11 41 PM IST