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Magic of Interest Rate
Feb 20 2012 | 0 Comments | 2149 Views

It may surprise you to know that when you take a mortgage, most of the time the interest payment exceeds the principal payment. Thus, even if it sounds like a cliché, it bears emphasizing it again.

Interest rate matters: Let's say you are buying a house for  Rs. 75 Lakh with a 33% down payment (your mortgage is for  Rs. 50 Lakh), and 20 years loan term.

Here are two quick numbers that highlights the role of interest rate (refer table below for details)

Key Summary for 20 years fixed Mortgage

Interest Rate
9% 10% 11%
Principal(Rs. Lakh) 50 50 50
EMI (Rs. Thousands) 45 48.2 51.6
Interest(Rs. Lakh) 58 66 74
Total Payment (Rs. Lakh) 108 115.8 123.9
  • For a 10% fixed rate loan, you end up paying around  Rs. 116 Lakh (EMI slightly above  Rs. 48 Thousands) in total including  Rs. 50 Lakh of the original loan amount and additional  Rs. 66 Lakh in pure interest (wow)
  • As you can see in the first and second column 1% increase(decrease) in interest rate increases(decreases) your EMI by around 7% ( Rs. 3.2 Thousands) and your total interest payment by around 13% (~ Rs. 8 Lakh) for the life of the loan (full term of 20 years)

Now assume that you are choosing between a fixed rate and variable rate scenario. There can be three basic interest rate outlooks for the future you should worry about while choosing the product.

  • 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. As demonstrated in the example, if you take the variable rate and the average rate goes up by 1% then your EMI and total interest payment goes up significantly.
  • Stable interest rate scenario: 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 insulates you from interest rate volatility.
  • Falling interest rate: This is the opposite of rising interest rate scenario; here there is a significant upside to go for a variable rate product due to interest savings.

We would like to add that the world of interest rate forecast is seldom this clear cut and simple. Often rising interest rate environment is immediately followed by a falling one due to recession fear. In these scenarios, it is advisable to look at the short term interest rate forecast (say next 5 years) and base your decision on that. Beyond that if your home loan is not what you want (say you have a fixed rate mortgage in falling rate environment) then you can always refinance at that time.

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