Sunil Raghu, my colleague in Ahmedabad, took a Rs18,65,000 home loan from a large private bank in December 2005. The cost of his floating rate loan changes in sync with the movement of market rates. At an interest rate of 7.75%, his monthly outgo or EMI (equated monthly instalment) worked out to be Rs14,000 for 18 years and five months. He paid his first EMI in January 2006.
Today, after little over one and a half years, Raghu’s home loan rate has gone up by 3.5 percentage points to 11.25%. As a result of this, his EMI has shot up to more than Rs18,000. And even after paying 18 instalments, he will have to pay 280 more EMIs. This means, the tenure of the loan has gone up from over 18 years and five months to close to 25 years.
Raghu, who is now paying a higher EMI and servicing the loan for a longer period, is certainly not happy with this development. He plans to shift to another bank, shopping for a fresh loan. Even there, he may not escape the escalation in the cost of loan and its tenure if the rates go up further.
A recent analysis of the Indian mortgage market, done by rating agency Crisil, says a 2% rise in interest rates could push the tenure of a 20-year loan to 43 years if the mortgage firm does not hike the rate but only extends the tenure of the loan. This means a 30-year-old borrower of a home loan who has hoped to repay the loan by the time she is 50 would actually be repaying the loan till she is 73, assuming there is no change in interest rates in future.
Indian mortgage players offer two types of home loans: fixed rate and floating rate. At fixed rate loans, the loan rate remains unchanged despite any change in interest rates, while the cost of floating rate loans changes with market rates. In a rising interest rate scenario, borrowers normally prefer to go for fixed rate loans and when the rates move downwards, they opt for floating rate loans. Banks and pure mortgage players, however, discourage borrowers from taking fixed rate loans as this creates asset-liability mismatches for them. Some of them, in fact, have completely stopped offering fixed rate loans.
Since the average age of the home-loan borrower in India is about 35 (down from 43 years in 2000), lenders do not prefer the tenure of a home loan beyond 20-25 years. This is because the retirement age for the salaried people is normally 60.
If the tenure is not made longer to take care of the rising interest rates, the other option before the lenders is to raise the monthly payment schedule or EMIs. According to the Crisil analysis, if the interest rate goes up by two percentage points for a 10-year home loan taken at 7.5% in 2003-04, the EMI will rise by 9.01%. For a 20-year loan, the EMI will go up by 15.71%. This essentially means that if the borrower was paying an EMI of Rs1,000 per lakh of home loan at the old rate, she will have to pay Rs1,091 for a 10-year loan and Rs1,157 for a 20-year loan now. For a four percentage point rise in interest rates, the EMI for a 10-year loan goes up by 18.44% and for a 20-year loan, by 32.38%.
For my colleague in Ahmedabad, the lender has opted for an increase in tenure of the loan as well as its EMI. Most lenders have been doing so. The objective is to limit the credit risk by maintaining the ratio of the instalment size to the borrower’s income, technically known as IIR (instalment to income ratio). If the rise in interest rate is gradual, the risk on IIR is less as the income level of the borrower also rises.
A low ratio indicates higher difference between the income and the instalment, which provides a cushion to the borrower to meet monthly expenses. A lower IIR always offers a cushion to the lenders as a higher IRR leaves the borrower with less money from her salary income to meet regular monthly expenses including other loans. An IIR more than 50% is risky and since the IIR takes into account the gross salary, an IIR of 60% leaves borrowers with very little money to take care of other obligations.
Most banks and mortgage firms have been able to keep IIR at 50% for the bulk of their loans, so far, by hiking EMIs as well as tenure of loans.
The situation is complicated as the hike in interest rate is accompanied by a sharper rise in mortgage prices. This has a bigger impact on the market as borrowers’ affordability is going down. Take the case of Rushali Shukla, a Mumbai-based teacher. In 2005-06, Shukla, with an annual salary of Rs320,000, wanted to buy a flat for Rs15,00,000. She wanted to take a home loan of Rs12,00,000 for 20 years at an interest rate of 9.5%. At this rate, her EMI would have been Rs11,186 and IIR 42%. For some reasons, she postponed the decision of buying the property to 2006-07. Meanwhile, three key developments have taken place. The price of the flat that she wanted to buy in a distant Mumbai suburb has gone up by 30% to Rs19,50,000. The interest rate has gone up to 11.5% and her annual salary has gone up by 12%. As a result of this, Shukla will now have to pay a higher EMI of Rs16,636 and her IIR will go up to 55.7%. She will probably not buy the property now.
With every hike in property prices and interest rate, the borrower’s affordability falls and the IIR increases. This explains why there is a slowdown in loan disbursements. If banks and mortgage players push hard in this market, we will see many home buyers fleeing, dropping the key in their letter boxes.
Tamal Bandyopadhyay keeps a close eye on all things banking from his perch as the Mumbai Bureau Chief of Mint. Please email comments to firstname.lastname@example.org