Home / Opinion / Turning the vicious home loan circle into a virtuous one

It was a lazy Sunday evening and I was getting ready to watch “Koffee with Karan" when I got a frantic call from a friend. I put the show for recording before proceeding to listen to her agonized conversation. She was extremely upset upon discovering that her home loan—which had an outstanding of 50 lakh in January 2008, a tenor of 156 months then (13 years) and a loan rate (floating) of 8.25%—had increased in tenor drastically, even after paying equated monthly instalments (EMIs) for 5 years 2 months without a single default. The outstanding tenor on her home loan was still 200 months (nearly 16.7 years) as on February-end 2014. Why this shocked her was because she had expected it to be less than eight years.

While she had paid 32.45 lakh through EMIs in the past 62 months (which works out to 65% on the outstanding of 50 lakh as on January 2008), a mere 26% of this was used for principal reduction. To complete the story: she had taken a loan in January 2006 for a term of 15 years. In a steady rate scenario, this loan would have ended by 2021. But now with so many upward revisions (0.50% hike every six months), the loan will finish off only by September 2030.

Loans are the most effective way to build assets of large value, like houses, in a hurry. However, they can catalyse a financial disaster for a long time to come, if not understood well.

Many of us have home loans whose tenor (balance months) has been steadily increasing over the past 5-6 years despite not missing a single instalment. Does it sound believable? It may not, but it is a reality. How and why does it happen? The culprit is the constancy of EMIs.

When the interest rates climb up, a bigger and bigger percentage of your EMI goes towards servicing the interest portion of the loan. This means that lesser and lesser of your outstanding principal amount is getting reduced. In the above case, in January 2008, 66% of the EMI was used to pay interest, which climbed up to 89% by the end of February 2014.

So, if this is the bitter truth, how does one counter it and move towards a debt-free life? As Theodore Roosevelt said, “Nine-tenths of wisdom is being wise on time." Often, people keep going deeper into the mess because they haven’t looked at their loan statement and have assumed that all would be hunky-dory as they have been religiously paying their EMIs. A periodic review of one’s financials will highlight this problem well in time. Unfortunately, in financial products, the market forces play an emphatic role in altering the direction as well as the speed of the expected outcome.

It has been observed that more often than not, the clients have a capacity to prepay the loan amounts by redeeming some existing investment option of theirs which would be fetching them returns (say 9.5%) way below what they would be paying on the loan taken (13.5% in this case), a negative carry of 4%.

Three effective ways of avoiding getting into this debt trap are: increasing the EMI every few quarters, pre-paying chunks of money towards the loan account, or a combination of these two. The first choice may work for people with consistency in cash flows, provided their inflows can make space for an increased EMI. The latter can be used by people who are likely to receive an amount of money (at least in excess of six months’ EMI) through bonuses, incentives, business gains, or another source. The third option is a combination of increased EMI and prepayment. It allows the loan taker to devise a schedule based on his cash flows.

Each of the above mentioned paths to financial prudence could end up either being facilitated or road blocked, depending on the direction the interest rates take, i.e. southward or northward, respectively.

Just as compounding of returns on investments can leave a magical amount at the end of the investment period, similarly reviewing (and then taking action wherever and whenever needed) can wonderfully expedite the reduction of the outstanding loan amount.

It wouldn’t be wrong to say that we all slog to earn. So why this callous attitude towards our hard-earned money? Why should we pay at a rate more than what we are earning on our money? And why shouldn’t we be interested in knowing how our money is faring every few months?

Deepali Sen is a certified financial planner practitioner, and founder and partner at Srujan Financial Advisers LLP.

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