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Product selection

By ResidenceBuy India  |  0 comments   |  1506 views  |   Feb 14 2012

 

Product selection:  Mortgage is a complex product with different characteristics that deserve close attention. Here are some important concepts/ factors:

Type of Home loans: Lenders provide different types of home loans. Understand which one you need

 

  • Home purchase loan: Basic loan to purchase 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 the loan to expand an existing home (say adding an additional room)

 

Borrower type: It is useful to opt for a joint home loan application (with spouse/parents) to increase your chance of approval. Moreover, you enjoy additional tax benefit due to joint application. Some key aspects of tax benefit:

 

  • Tax benefit on principal amount: 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: 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).

 

Down payment: This is the share of the house value you (borrower) pay to the seller. Bank 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 bank finances 80% of the value then the borrower pays Rs. 8 Lakh and the bank finances Rs. 32 Lakh for the property.

 

Term of loan: This is the duration for which the loan is taken. Normally it ranges from 5 to 20 years. Note that there is a tradeoff between your immediate commitment in the form of EMI and long run cost of high interest payment. 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.

 

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 tenure 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 of around Rs. 116 Lakh including principal payment) over the life of the loan. Reduction of interest rate to 9% leads to a drop in the interest cost to Rs. 58 Lakh, a significant reduction.

 

Effective interest rate: The reported interest rate on the home loan may not be the effective interest rate you pay. The key is to understand on what balance you are paying your interest on. There are three main types of balance reduction schemes:

 

  • Annual reducing: Here the balance reduces at the end of the year, so you continue to pay interest on a portion of principal you have already paid down.
  • Monthly reducing: Balance reduces every month as you pay your EMI. This means the EMI and lifetime interest cost for the monthly reducing system is less than the annual reducing system (say, for the same 10% 15 year fixed rate loan).
  • Daily Reducing: As the name suggests, the balance reduces from the day you pay your EMI. For any given product this is the best scheme.

 

Fixed Rate loan: The rate of interest remains unchanged during the term of the loan. Buyer is protected from the risk of interest rate increase in the future, but cannot benefit from a drop in interest rate. As the fixed rate loan is immune to interest rate variation, they tend to be more expensive than variable rate loans (see below).

 

Variable rate loan: variable rate mortgage indicates changing interest rate (based on a benchmark rate) during the tenure of the loan. Here the rate is adjusted upward or downward based on the movement of the benchmark rate.

 

Hybrid loan: A hybrid loan is a combination of fixed rate and variable rate loan. Here you enjoy the benefit of a fixed rate loan for a pre-specified period, on expiration of which the interest rate is anchored to a benchmark rate and varies with it. One noteworthy product in this universe is a product that starts with a low teaser rate and resets to a significantly higher rate after a pre-specified period. There are several dangerous aspects of this product. We note a couple here:

 

  • Negative amortization:   The low teaser rate provides you upfront payment relief with low EMI, however your accrued interest is added to the principal amount. Thus while you are enjoying the low EMI your future interest burden rises.
  • Sudden payment rise: After the expiration of the discount period the interest rate resets to a higher value and along with a higher principal (due to negative amortization) your EMI rises drastically. This may come as a shock to a borrower after getting used to low EMI in the beginning.

 

Comparison of fixed vs. variable rate loan: Product choice under different interest rate scenario (see table below): Interest Rate scenario and 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 (see our refinance section below).

 

Processing and administrative fee: This includes legal verification, technical verification, loan processing and other costs that lender often adds to the loan amount. This accounts for around 0.5%-2% of the loan amount. Assuming 2% of the loan amount, a home loan of Rs. 50 Lakh effectively increases to Rs. 51 Lakh. Understand that not only you pay that additional Rs. 1 Lakh; you also pay interest on it over the life of the loan.

 

Other charges: This includes the following:

 

  • Prepayment penalty: 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. Currently RBI is proposing to abolish this for variable rate loans.
  • Delayed payment fee: The delayed payment fee is charged when the monthly EMI payment is delayed. This fee is added to the principal amount so a borrower also incurs interest cost on these missed payments.
  • Foreclosure Fee: If a borrower discontinues the monthly EMI payment then the lender will foreclose on the property. The associated fee for this foreclosure process is added to the principal and collected from the borrower subsequently.

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