So you think cheap home loans are always best? Stop. Think again. This is only partially true because the advertised interest rate is just one of many criteria that must be looked at when taking a loan. And, in the context of a home loan price war in the market, take time out to understand what these low rates could mean for you and what other factors must be looked at.
Before you zero in on a loan, keep in mind two major factors:
1. Quantitative factors: This relates to the loan amount, the interest rate, the tenure of the loan and the EMI you will be bound to pay contractually.
2. Qualitative factors: This relates to the flexibility your lender can give you under the terms you have signed up for, as well as its service commitment to you as a client.
Taking a home loan is a big decision, and one you could be stuck with for a long time—you are taking on a contractual obligation to repay the loan over a period that could last for 10-20 years. A lot can change during this time—the prevailing economic conditions and market interest rates might change, you might want to move to a bigger home, or prepay your loan if you end up having the means to do so. So, let’s understand how these loans work.
How do cheap home loan rates work?
When a bank or lender announces that it is offering a home loan with a starting rate of 8%, this is the rate that sticks in our minds. However, the first thing that you need to understand is that the headline rate of 8% being offered is just a teaser rate. This rate only exists for a starting period, and after this predetermined time, it resets to a higher rate. The starting period could be anything from one–three years. After this period, the loan adjusts to something higher that you have contractually agreed to at the time of signing or is calculated based on the lender’s internal rate (the lending bank’s prime lending rate or PLR).
So, by the fourth or fifth year, after the initial reset, the rate could be above 10%, and your EMI (equated monthly instalment) might turn out to be higher than what you might be comfortable with.
Past experience from other countries has shown—particularly during the sub-prime crisis in the US—that those who took low teaser rates to buy homes, tempted by cheap rates, were often the ones who ended up in financial trouble a few years later. This is because when the rates adjusted upwards, they did not have sufficient income to pay the higher EMI.
We are not for a moment suggesting that the recent price war using cheap home loan rates will result in an economic crisis in India, or that the banks offering these rates are doing the wrong thing. All we are highlighting is that that there is more to it than meets the eye, and that one shouldn’t make the impulsive decision of going with the cheapest rate.
But isn’t cheap good?
As we mentioned earlier, there are several qualitative factors that need to be looked at.
1. Understand long-term implications: Home loans are long-term borrowings, often with a tenure of 10–20 years. So what you should really be thinking about is if you going to be better off in the long term or not, not just in the first year.
Don’t fall for low teaser rates and get locked in an inflexible arrangement. Has your lender explained to you the long-term implications that taking a loan with a low teaser rate that resets in a few years can have on your finances? What you need to ask yourself is whether the average long-term rate is lower or if it is just the initial teaser rate that is lower. Finally, understand if you can still afford the EMI after the loan has been reset to a higher rate.
2. Understanding PLR: Every bank has an internal interest rate according to which all its other loan rates are priced. The bank has full discretion to set this as it pleases. The details of how the PLR is arrived at are confusing to most of us, and the bank can exploit this ambiguity to its advantage.
Ask your lender to explain to you how the bank’s PLR might fluctuate and how these changes might affect you in the long run. At the very least, ask the bank to share its history of how the PLR has fluctuated in the past and how it affected the home loans they had offered. Ask your friends for their experiences if they have taken home loans in the past.
3. Penalty for balance transfer: Find out if there will be a penalty for a balance transfer. You might realize a few years into your loan that another bank is offering you better overall terms, but that you will not be able to transfer your loan balance to that bank because your current bank will charge a high penalty for transferring the loan.
Lenders waive the prepayment fees if you pay out of your own funds, but not everyone might have such a large pool of funds. Could the penalty fee be so high that it offsets the benefit of taking a home loan with a cheap teaser rate? Understand how flexible your lender is going to be and has been with other clients in the past.
4. Processing headaches and customer service: Most critically, understand the customer service aspect of your loan. We have seen enough clients go for cheap teaser rates from banks, only to suffer because the disbursement is not made on time or is not made at all. Don’t fall for a low rate only to be hit with the risk that your property purchase might be delayed because the lender is not processing your file in time. Often, the bank will publicize the low rate to tempt you, but then sit on your application for a while and could choose to not lend to you at that lower rate because you don’t meet the bank’s loan underwriting criteria.
A good deal is not just one where the initial rate is attractive but rather one that is accompanied by the right level of flexibility, responsive service and cheap lifetime cost of ownership. Don’t just blindly go in for a cheap headline rate—you might end up paying for it!
Insure your home loan
If you are planning to take a home loan, it is advisable to take a home loan protection plan along with it. Your housing loan is a liability you will have to bear for anywhere between 10 and 20 years. What if something adverse happens to you and you are no longer capable of fulfilling your loan obligation? With a home loan protection plan, you can rest assured that in the event of any mishap, your family’s basic living conditions will not be disrupted. Rather than your home being repossessed for non-payment of liability, the insurance company will step in and take over your liability towards the lender.
NRI or PIO? Invest in mutual funds
If you are a non-resident Indian (NRI) or a person of Indian origin (PIO) and want to invest in the country, consider investing in mutual funds directly for the following reasons:
Diversification: The basket of stocks available to India-dedicated ETFs (exchange-traded funds) is limited.
Performance: Since mid-2006, Indian mutual funds have outperformed India-dedicated ETFs by a significant margin.
Taxation: There is no tax on dividend income and long-term capital gains tax is zero in India when investing in Indian equity mutual funds.
Make sure your shares are credited to your demat account
Always make sure your shares are credited to your demat account. If they are not transferred to this account, your broker can operate them without any authorization from you. Remember, if your broker sells your shares without your permission, you are exposing yourself to the danger of losing money when the price appreciates. Written consent is required every time a broker wants to sell your shares after they have been transferred to a demat account. Every broker provides a debit instruction slip booklet, which has to be filled every time the investor sells the shares. You can also give a power of attorney to your broker that can empower him to issue instructions from your account.
Financial transactions via cellphones
Nokia is planning to launch a service enabling people to make financial transactions via their cellphones. The “Nokia Money” service will make it possible “to send money to another person just by using the person’s mobile phone number, as well as to pay merchants for goods and services, pay their utility bills, or recharge their prepaid SIM cards”. The service, available 24 hours a day, will be rolled out from early 2010. Nokia said it was building up a large network of Nokia Money agents where consumers can deposit money or withdraw cash from their mobile accounts.
(Dhruv Agarwala and Kartik Varma graduated from Harvard Business School and are co-founders of New Delhi-based iTrust Financial Advisors)
Content provided by iTrust Financial Advisors
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