Over 50% of credit advanced to individuals/households come in the form of Home Loans – making it the single largest product category in retail lending. Buying or building your home is perhaps the most significant financial decision you’ll ever take. So, you better be clear on what you’re getting into.
Home Loan is a product which can help you fund your home construction, purchase, repair, or renovation. It is another type of Secured loan which treats the underlying house as a collateral, meaning the bank has the right to repossess the house in case of a default.
This collateral may also be an existing property of the loan applicant instead of the property being acquired.
Banks and Non-Banking Financial Companies (or “NBFCs”) typically give Home Loans covering up to 80-85% of the cost of property (termed as “Loan-to-Value” or “LTV” in banker parlance), with the rest to come directly from the customer (i.e. your down-payment or equity). Banks are subject to LTV caps as set by RBI, as shown below (as per notification dated June 7th, 2017):
These loans can be structured to be repaid over a duration of up to 30 years (“loan period”) via Equated Monthly Installments (EMIs). An EMI plan essentially spreads the total principal & interest due equally over the loan period and is chargeable on a monthly-basis.
What Interest Rate?
Like Car Loans, your Home Loan EMI would be calculated based on the principal amount you borrow, the applicable interest rate, and the loan period.
The applicable interest rate is set by the bank and for Home Loans is mostly “Floating” in nature i.e. it changes throughout the loan period subject to RBI rates. Certain Fixed interest rate products are also available.
This interest rate depends on individual factors:
Macro factors drive the benchmark interest rate in the country which in turn influences all consumer facing interest rates, as explained earlier.
You can check an online loan marketplace to get a sense of the applicable interest rates. They are usually expressed on an annualized basis.
The floating rate is usually structured as:
1-year MCLR + Spread
In layman terms, MCLR or “Marginal Cost of Funds Based Lending Rate” is the minimum allowed interest rate below which a scheduled commercial bank or NBFC is not allowed to lend. It is set by the Reserve Bank of India (RBI) and is driven by short-term interest rates set by the Monetary Policy Committee (MPC). The additional Spread includes the lending banks’ margin and the customer’s risk premium.
Floating Interest Rate, as the name suggests is not constant. It “floats” during the loan period depending on RBI’s monetary policy actions. Floating interest rates ensure that borrowers can benefit from any future rate reductions by the RBI after they have already taken the loan.
Processing fees: The bank would charge a processing fee (structured as a fixed amount or as a percentage of notional – sometimes waivered during negotiations). This fee would not be netted off the loan amount but is charged as an add-on.
Prepayment Charge: The bank does not want you to prepay your principal before the loan period ends as it will lose the interest income it makes (again the bank is conscious of the power of compounding). Hence, they typically charge a prepayment charge (i.e. if they allow prepayment or pre-closure) as a percentage of loan amount when you end up prepaying. It is ironic as you will be charged for paying back before time. For Home Loans however, most banks waive off the prepayment charge.
Loan Cancellation: There are loan cancellation fees, usually a fixed amount per cancellation.
Documentation Charges: The bank will charge for any documentation it needs to administer e.g. for obtaining No Objection Certificates, preparing statement of account, for the CIBIL report, amortization schedule etc. They are not very significant.
Legal Fees: There is a separate Legal fee to pay a lawyer to verify the property being funded via the Home Loan.
Late Payment Charge: Late payments are penalized through a Late Payment Charge as a percentage per month on the outstanding installment. Even with the charge, a late payment must be avoided to maintain a good credit score.
Conversion Charges: If you’re switching your interest rate from floating to fixed or vice-versa, there are conversion charges levied by the bank, usually denoted as a percentage of outstanding principal amount.
Things to Watch
1. Shorter is the loan period, lower would be the interest rate applicable
2. A higher down-payment from you will result in a lower interest rate
3. A fixed interest rate helps you plan your finances better as you will have a sense of your dues upfront. If RBI pushes downs short-term rates in the future, you will not benefit. If RBI increases short-term rates in the future, you will benefit
4. A floating interest rate ensures you benefit when RBI pushes down short-term rates. It also means you will get hurt when RBI’s rates are going up. Fixed rates would always be slightly higher than the corresponding floating rates.
5. Do the math around whether you save any money if you’re prepaying your outstanding loan amount. If you prepay close to your loan period end, you may end up paying more via prepayment charges
6. There are separate schemes for Women borrowers, do ask your bank
7. Some banks ask for a Guarantor, most banks don’t
8. Home Loans are eligible for certain income tax exemptions. Under section 24 of the Income Tax Act, tax benefit can be claimed on up to INR2L out of the interest component of your Home Loan (for self-occupied house). Separate deductions under Section 80C on principal repayment (up to INR1.5L), for stamp duty, and for first time buyers under Section 80EE (up to INR50,000). Co-owners can collectively take the benefit of tax deductions.
9. Try taking a Home Loan at the end of the month. You may be able to negotiate better rates as banks have to fulfil their monthly targets
10. Applying with a co-applicant (e.g. spouse, parent) can increase probability of approval as both applicants’ income is taken as a reference to determine the loan amount and interest rate
Next week we will do a similar exercise to better understand Education Loans.
This will be a recurring column published every Friday under the title: “How to Make Sense of the Indian Economy”.