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How to Choose a Home Loan Product

By ResidenceBuy India  |  0 comments   |  1364 views  |   Feb 24 2012

Which Home Loan? Lenders provide different types of home loans. Understand which one you need.

  • Home purchase loan: Basic loan to purchase a home
  • Home improvement loan: Loan provided to do necessary repair and improvement to an existing home
  • Construction loan : Loan to construct a home
  • Home extension loan: As the name suggests, this is a loan to expand an existing home (say adding an additional room)

 

Joint Loan Application: Applying for home loan jointly (with parents or spouse) increases the chance of home loan approval. You can also enjoy additional tax benefits in joint application. Note that lenders don't allow you to apply for home loan with other relatives. The key reason is that if there is a future dispute between the joint borrowers then the income cannot be pooled for the eventual recovery of the loan.Furthermore one should also account for tax implication of jointly applying for home loan. Key tax benefits of taking a home loan include:

  • Tax benefit on Principal and other payment: You can avail of tax deduction on principal amount, stamp duty, registration fee, and other expenses for the purchase of the property. In order to enjoy the deduction you should not sell it before five years (if you do sell it before that period then the deduction will discontinue and all previous deductions will be added to your taxable income).
  • Tax benefit on interest payment: You can claim deduction for the interest paid on a housing loan (and on loans taken for repair, renewal or reconstruction of an existing property) with deduction calculated on an accrual basis. For owner-occupied property (financed by a housing loan taken after 1 April 1999), interest deduction is up to Rs. 1.5 Lakh a year. For this to apply, the acquisition or construction of the property should be completed within three years of the time at which the loan is taken. For co-owned property, each member can get this deduction separately (so deduction up to Rs. 3 Lakh for a home loan taken jointly by husband and wife). For rented property this deduction is the full interest amount (on accrual basis) along with a further flat deduction of 30% of the annual property value (as described in section 23 of Income Tax act of India).

 

Interest rate: Interest rate is the single most important deciding factor in choosing a home loan. Mortgage products are often differentiated based on interest rate the borrower pays during the term of the loan. While a fixed rate mortgage implies a fixed interest rate during the life of the loan, a variable rate mortgage indicates changing interest rate (based on a benchmark rate) during the term of the loan. Within the variable rate product universe, some mortgage products charge a low initial interest rate (called a teaser rate) that increases substantially after a specified period. If you decide to take these types of loans then be aware of the fact that sometimes the EMI increase after rate reset can be quite high.
Irrespective of which product you choose, interest cost is a significant component of your total mortgage payment and often exceeds the principal over the lifetime of the loan. For example, on a principal of Rs 50 Lakh with a 10% fixed rate mortgage for 20 years you end up paying Rs. 66 Lakh in interest charge ((total payment of around Rs 116 Lakh) over the life of the loan. However, reduction of interest rate to 9% leads to a drop in the interest cost to Rs. 58 Lakh. In fact, you can use our morgage tools to explore possible interest savings based on different combinations of interest rate and term.

 

Loan term: This is the duration for which the loan is taken. Normally it ranges from 5 to 20 years.. Borrowers often look at loan term purely through the prism of EMI;i.e. a longer loan term implies a lower EMI for any given interst rate. However it is easy to ignore the role that interest cost plays in this framework. Keeping everything constant, a short loan term guarantees a quick pay off (and low total interest fee) but a high EMI. The case is opposite for loans with longer loan term. We suggest that if you have the capacity to pay a high amount today then take advantage of it and pay-off the mortgage quickly. Check out our mortgage tools to calculate the trade-off between EMI and total interest cost and to further understand the trade-off between EMI and interest cost by changing the loan term for any given product.

 

Loan amount:This is the amount you receive from the lender which, among other factors, depends on the following characteristics: ·Your loan repayment capacity: Lenders determine this based on borrower's current and future income, current assets, current liability, and past payment behavior ·The value of the property: This is often based on independent appraisal of a given property. 

 

Down payment: This is the share of the house value you (borrower) pay to the seller. Lenders often finance a portion of the value of the house that ranges from 65% to 80%. The rest has to be paid by the borrower. Say the house value is Rs. 40 Lakh and the lender finances 80% of the value, then the borrower pays Rs. 8 Lakh and the lenderpays Rs 32 Lakh for the property. §Fixed rate vs. Variable rate:This is part of a wider choice of products available to a buyer while choosing a home loan. The fixed rate assures a constant interest rate during the life of a loan. The case is opposite for variable rate mortgage, where the interest rate fluctuates based on a given benchmark rate. The potential advantage of fixed or variable rate depends on the borrower's outlook of the interest rate scenario.


Interest Rate scenario and home loan product choice

Product Choice Interest Rate Scenarios
Rising Stable Falling
Fixed Rate Yes Yes No
Variable Rate No No Yes

  • Rising interest rate: If you are in a rising interest rate scenario, then it makes sense to lock in the low rates now by taking out a fixed rate mortgage. Under a variable rate mortgage, rise in the benchmark rate will lead to higher interest rate on your loan, leading to a higher EMI and higher total interest cost.
  • Stable interest rate:If the interest rate will remain more or less stable then you should be indifferent between the fixed rate and variable rate. However, we will advise you to go with the fixed rate as it saves you all the worries about volatility of interest rate.
  • Falling interest rate:This is the opposite of rising interest rate scenario. Here there is a significant upside in going for a variable rate product due to potential interest savings.

    Other scenarios: Interest rate outlook tends to be fluid and may change direction within a short period of time.Often rising interest rate environment is immediately followed by a falling one due to recession. So it is advisable to look at the short run interest rate forecast (say next 3 years) and base your decision on that. Beyond that if your product is not what you want (say you have a fixed rate mortgage and falling rate environment) then you can always refinance at that time

 

Prepay charges: This is one of the hidden charges that most buyers overlook. A loan can be prepaid (before the end of the term) either in part or in full at any time. However, most lenders have an upper limit on the number of times a person can prepay the loan in a year. Until recently, lenders charged a penalty for part or full prepayment. However due to increased competition, now lenders allow repayment without any charges.

 

Stamp duty: Stamp duty is the tax a homebuyer pays to the State Government for buying a property. By paying the proper stamp duty, you can get your property registered and enjoy a clean title to your property. The tax varies from state to state, but it is usually a flat fee plus a certain percentage of the property value (both of which changes with the value of the property). The stamp duty is usually paid on the execution of the sale or the day after.

 

Locking interest rate: Locking interest rate means a lender promises to hold a certain interest rate and a certain number of points for you, usually for a specified period of time (as the loan application is processed). Points are additional charges imposed by the lender that are usually paid upfront by the consumer at settlement but can sometimes be financed by adding them to the principal amount. One point equals one percent of the loan amount.


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