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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
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:
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:
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:
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 |
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: