Keep an eye on that interest rate

Published in The Hindu - Sunday Magazine on Aug 3, 2008

When availing of variable rate home loans, make sure you have enough breathing space.

In my previous column, I explained that your home (purchased with an 80 per cent home loan) should double in value at least every six years to make it a reasonable investment (and to match the opportunity cost of not taking a home loan and investing in mutual funds). In your case, the appreciation condition seems to be fulfilled, but I would request you to double check the hypothesis for the following reason:

Although real estate prices are based on supply and demand in the long term, in the medium term it is counter-cyclical to the interest rate regime i.e. home rates increase when interest rates are low and stagnate or dip when interest rates become high (current scenario).

If you are still convinced about the appreciation potential of your property choice, then the next step is to prepare for the demon of further interest rate increase.

Allow a confortable margin

Imagine you are studying for an exam thinking the cut-off for passing it is 40 per cent. But after you take the exam, the cut off is revised to 50 per cent. What would you do? The only way to protect yourself is to prepare for the exam by allowing a comfortable margin — say by targeting 60-70 per cent. This is similar to the situation with a variable rate loan that has an inbuilt risk of rate increase.

How do you ensure that you have enough breathing space in the event of a rate increase on your home loan? Here, you need to be more careful than the bank. Although banks are prudent in offering loans with EMI up to 50 per cent of Net Monthly income, this does not take into account the personal/ family commitments you may have during the loan tenure or more importantly, the increase in interest rates (for variable rate loans). Under the current inflationary scenario, it will not be surprising if home loan rates rise further by 3-4 per cent in the immediate future. So, if you are taking a 11 per cent loan, you need to be prepared to be able to pay the EMI even if the rate is increased to 15 per cent in the medium term.

To help you plan the impact of interest rate increase on the monthly EMI amount, please refer the table at right.

Tips for reading the table: If you want to know by how much your monthly EMI would increase if the interest rate is increased from 11 per cent to 13 per cent, when the POS of your loan is Rs. 30 Lakhs and remaining tenure is 20 years, then look for the intersection of 20 years in the row and 30 lakhs in the column; the intersection cell has the value Rs. 2067. This is the monthly EMI increase for one per cent increase in interest rate. For two per cent increase in interest rate, you need to multiply Rs. 2067 by 2 = Rs 4134 (approximately)