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Of home loans and interest rates
Swapnil Pawar, PARK Financial Advisors
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August 17, 2007

Many home loan borrowers have experienced the pain of rising interest rates in the recent past. Monetary tightening by Reserve Bank of India [Get Quote] left many families see their EMI burden rise by as much as 25 per cent.

Where are interest rates expected to go from here? What should the new home buyers do? What should the existing home buyers be aware of?

We answer some of these questions in this article.

Interest rate cycle nearing its peak

The interest rate hike by RBI was part of a conscious strategy to rein in inflation and curb credit growth in Indian economy.

With wholesale price inflation well below 5 per cent now, experts are of the opinion that RBI might be done with the rate hikes for now. The recent decision of RBI to increase Cash Reserve Ratio instead of increasing the benchmark interest rate was an indicator of this trend.

There are of course some voices amongst the experts that RBI might still take a view that inflation numbers are still on the higher side. That said there seems to a consensus that in all likelihood, the interest rate hike in near future, if any, will be one-off.

In short, the interest rates are either already at their peak or nearing it.

What it means for the new set of home buyers is that they should only opt for floating rate loans.

You might hear stories of how floating rate borrowers were so very adversely affected by all the interest rate increases and how a smart borrower locked in a fixed rate of 8 per cent in 2004. However, being swayed by that to borrow with a fixed rate now is doing precisely the thing that would make you into an interesting anecdote 3 years hence as to how so-and-so was scared into a burdensome fixed rate loan and then interest rates only went down thereafter!

One might argue that it is better to wait and watch while interest rates come down. However, we believe that if the home purchase is for own use (and not investment alone), it should not be affected by the interest rate cycle. Floating rate loans will anyway ensure that you get the benefit of interest rates coming down in future.

Interest rates charged to you may be sticky downwards!

It has been observed that banks are prompt to increase the interest rates on your loan when the benchmark interest rates go up. However, often the same degree of alacrity is not shown by them in reducing your rates despite the benchmark rate going down.

While banks may have their own reasons as also clauses and disclaimers in the loan agreement to support this, as a borrower you need to vigilant of the rates charged to you. Even if your EMI has not changed with the increased interest rate (owing to increase in tenure instead), you need to watch out for the downward revision of interest rate on your loan (your loan tenure should come down with the same EMI).

So in the coming months, if the interest rates do come down, make sure to call your relationship manager from the lending bank and check if the downward revision in your interest cost has happened. Depending on your loan agreement, this might require a request letter from you in some cases. Clarify the same with the relationship manager.

Reduction in tenure or reduction in EMI?

While the interest rates rose, lenders gave borrowers the option of increasing the tenure or increasing the EMI. Similarly the reducing interest rates would mean the borrowers can either reduce the tenure or reduce the EMI.

Unless there are very pressing reasons to reduce the EMI, it is prudent to opt for a reduction in tenure of the loan. Not only it ensures a lower effective interest paid out over a long period of time for you, it also provides you the flexibility of increasing tenure at a later date in case the rates increase again.

What should an existing borrower do?

The interest rates were at their lowest at the beginning of the recent retail credit boom. The huge growth in home loans was driven by a combination of factors including low interest rates. Majority of borrowers have borrowed either at the trough of the interest rate cycle or on its way up.

Hence so far, we have not seen any well defined trends in terms of the behavior of lenders in a decreasing interest rate scenario - especially while dealing with their existing loan portfolio.

On that front, the existing borrowers need to take an activist approach to ensure that they benefit from the interest rate reduction just as they were affected by the interest rates rise. The clause of buyer-beware applies here too!

The author is a director at PARK Financial Advisors Mumbai.

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