High EMIs? Tips to tackle them

Your dream home and flashy set of wheels just got a bit more expensive with the Reserve Bank of India announcing yet another hike in interest rates. Now, after its second revision since June, the reverse repo stands at 6 per cent and the repo at 7 per cent.

As expected, soon after this, several banks announced higher rates of interest on home and auto loans. HDFC, SBI, PNB, Oriental Bank of Commerce, LIC Housing Finance and Bank of Baroda have hiked their home loan rates in the range of 0.25-1 percentage points.

The repo and reverse repo rates set the direction for other lending rates. A rise in the reverse repo rate raises the cost of borrowing funds of banks, leading to a rise in lending as well deposit rates. For protecting its net margin, a bank typically factors in a rise in the reverse repo rate by increasing its lending rates on all retail loans. Ultimately, it is the customer who has to pay a higher price.

There are plenty of customers like Preeti Harkare in Mumbai and other cities who want to buy their dream home but do not know what to do with constantly rising interest rates. We look at some options.

How to tackle rising home loan rates? Bankers are divided over which is a better product for home loans - a floating rate or a 2-in-1 loan. The latter is a combination of fixed and floating and some see it as an ideal product to hedge in a rising/falling interest rate regime.

Explains P Sridhar, senior vice president, personal products division, IndusInd Bank, "In a rising interest rates scenario, one option is that the customer can try to advance his purchase and the loan before the interest rates harden further. He can also opt for a hybrid interest scheme that is part fixed and part floating - depending on his expectation about the future rate of interest, the ratio of loan taken under the two schemes can be varied."

This being the case, home loan seekers should consider opting for a 2-in-1 loan where the rate of interest is fixed for 3-5 years. This will protect them from a potential interest rate hike in the near term. At the end of this term, they have the option to either continue with the 'fixed' rate (if interest rates continue to rise) or migrate to a floating rate loan.

Fixed vs floating

On the other hand, many banks and financial institutions are of the view that despite sustained hardening of rates, floating rates would still be a safe bet. Analysts aver that floating rate loans are favoured because fixed rate loans are usually more expensive than floating rate loans (approximately 1.5 per cent higher now, 0.5-1 per cent earlier).

Even today, despite all the rate hikes, 85 per cent of the new loans are still booked at floating rates. Bankers say that if the outstanding term is below ten years, floating rate would be a better option as you would benefit from the lower rate for the first few months.

Explains Sujon Sinha, UTI Bank's head, retail assets, "Interest rate fluctuations always depict a two-way movement. Over the time horizon of a 15-20 year loan, the rate gets evened out when it is on a floating basis."

He adds that with a rise in the disposable income of salaried employees, it would be easier for them to service a floating rate loan.

The rates have been rising for the last 18 months and the incremental rise of the rate would be lesser than paying a 1.5 per cent higher fixed rate for the same tenure. If you stick to your floating rate loan, a half a percentage point increase in borrowing rates could increase your tenure by 25 months. As most institutions prefer to increase the tenure rather than the EMI, it will not affect your monthly outgo.

Should you switch to fixed rate loan?

Converting to a fixed rate loan now may not be a prudent decision, say bankers. If you borrowed at floating rates and want to convert to fixed, you will have to pay 1-2 per cent conversion charges on the outstanding principal amount. Let's assume you took a loan of Rs 15 lakh at 8 per cent for a 20-year tenure and have paid a principal of Rs 100,000. If you convert the balance to fixed rate of interest at 10.5 per cent, you will have to pay around Rs 21,000 as conversion charge. This, in turn, would increase your EMI or extend the tenure of the loan.

If you still want to give fixed rate loan a shot, ensure it is a true fixed-rate product and not a fixed rate linked to money market conditions. True fixed products have a fixed rate throughout the tenure of the loan unlike the latter in which the banks have the liberty to tinker with the rates. The difference is that a true fixed product, offered by a few players, charges 1.5 per cent higher than the other.

Negative impact on auto loans. On every occasion that the RBI has hiked its reverse repo rate, leading auto financiers have increased their lending rates. Interest rates on car loans have surged by at least 3 percentage points since December 2005. The interest rate on auto loans falls in the range of 13.5-14.5 per cent at present.

So what should be a borrower's strategy to minimise the repayment burden? If you do have money to spare right away, ask the financier to increase the down payment. This way you would have a smaller amount left to repay and you can repay it much faster.

Explains an SBI official, "Higher down payment would take care of the repayment obligation and would keep the EMI at the desired level. However, the down payment should be measured in comparison to the repayment capacity of the borrower and keep the interest cost manageable."

Moreover, the borrower gets an upper hand in the negotiation if he gives a higher down payment. Secondly, try and take a shorter tenure loan. A prominent car dealer in Mumbai points out that a car loan, unlike a home loan, does not offer tax benefits.

Lowering the repayment tenure also helps the borrower get a better deal on interest rates, he adds.

According to industry estimates, 85 per cent of all new car sales are backed by auto financiers. However, motor vehicle sales in India have remained buoyant despite the rate hikes, thanks to sales incentives and discounts offered by vehicle manufacturers and car financiers.

Explains Sridhar, "The borrower can exploit attractive schemes floated jointly by the auto manufacturer and financier during specific seasons. Since the interest rates are normally fixed, the seasonal offers will apply throughout the tenure of the contract."

Better late than never

For the time being, indicators point to a northward journey of the interest rates. So, if you have already missed the low interest rate bus, do not delay any further. Most bankers say that rates would inch up for another two to three years. Many banks have kick-started the hikes in lending rates and others are preparing to do so. Get going and clinch a good deal before it gets even more expensive!

How to Choose a Floater

Floating rate loans are more attractive because they cost one or two percentage points less than a fixed rate. But do choose a floater carefully. Have you ever asked the question: what does it float with respect to?

The bank benchmark, the home loan agent will quickly reply. But who fixes the bank's benchmark or the Prime Lending Rate. Did you think it was the Reserve Bank of India? No, it is not the RBI but banks themselves who fix it.

So you have a loan on a rate that can move up and down only if the bank moves its PLR up or down. Banks move the PLR up, but not many moved it down when the rates fell three years back. They just introduced new PLRs, yours remained where it was.

You need to find out a rate that is benchmarked to an independently decided rate like the MIBOR or the Mumbai Inter Bank Offer Rate. ING Vysya Bank has such a product. Or you could check out the Kotak Bank home loan floater that is pegged to its one year FD. But be sure to chase this option, for the bank also has its own PLR benchmark option.