Homebuyers must plan for future increase in EMI by using ‘margin-of-safety’ principle.
As residents in a high growth developing economy, we need to be prepared to face high interest rates from time to time – thanks to inflation!. The downside of high interest rates is that loans become more expensive. Now we all know who bears the major brunt of this. The homeowners of course – because of 3 reasons: 1) among individuals, home owners typically take the largest quantum of loan 2) among retail loans, home loans have maximum tenure – 20 years on average 3) most home loans in India are variable rate loans; even the banks that do offer fixed rate loans build-in a reset clause which allows interest rate on the loan to be increased in the event of a spike in prevailing rates.
If rise in interest rate is inevitable, the only way to deal with it is to prepare for it, before you purchase your home. Once you make the purchase decision, you will most probably lock yourself into a loan whose repayment is going to consume a good portion of your earning life.
The Margin of Safety Principle
A commonsense approach to prepare for future increase in your home loan interest rate is to evaluate the worst-case scenario, and then build a margin of safety. If you examine how interest rates have moved over the past decade, you will notice that the maximum level of home loan interest rates during this period was around 14% p.a.. So it may be reasonable to assume that the worst-case scenario is home loan rates climbing back to 14% p.a. during the next decade. If it does, you would have two options: make higher EMI payments or settle for extending the tenure of your loan. Although the bank earns more interest income if you choose the latter, for the customer the former option is any day better. After all, why would you want to pay interest charges to the bank for extra years? And who knows -may be you want to take an early retirement – in which case you would be unable to extend the loan tenure.
The margin of safety question is - can you pay the higher EMI charges if your home loan interest rate increases to 14% p.a. from the current level of 9% p.a.? To know if you can, the first thing you need to do is calculate what would be the EMI amount at 14% p.a. interest rate. Then you need to decide if you can afford this higher EMI level “today”. You may counter my stance as being unnecessarily extra cautious, by arguing that even if an increase in EMI were to occur, it is likely to happen only at some point in the future - when your salary would have increased and you may be able to accommodate the EMI increase if any. I disagree. These days, most couples become homeowners at around the time they have their first kid. So even if their salaries increase, family expenses are also likely to increase. It is better to be sure upfront (at the time of purchasing your home) if you can afford a higher EMI in the event of an upward revision in interest rate on your home loan. This would save you from the agony of trying to make both ends meet when the event occurs.
If you are not sure you can meet the higher EMI commitment corresponding to the worst case scenario of 14% p.a. interest rate level, it may be better for you to settle for a smaller, less expensive home at the time of purchase. This way you can start with a smaller loan amount and lower EMI, leaving sufficient cushion (margin of safety) for potential increase in EMI at any point in the future.
Sample calculation using Microsoft Excel
Following is an example that will help you calculate the maximum loan amount you can “afford” after considering a margin of safety, which will protect you in the event of increase in interest rate.
Let’s say the maximum EMI you can afford is Rs 30,000. At current market rate of 9% p.a. for variable rate loans, this EMI commitment can make you “eligible” for a 20-year loan of Rs 33.34 lacs. You can calculate your loan eligibility in Excel by using the formula PV(interest rate per month, loan period in months, monthly payment). For our example that would be PV(0.75%, 240, 30000) = 33.34 lacs.
But a loan for Rs 33.34 lacs would leave you with no margin of safety if the interest rates were to rise further. e.g. If the interest rate is reset to 14% p.a immediately after you take the loan (the worst case scenario), your EMI would increase to Rs 41,463 – an amount that you may not be able to afford. (Note: The later the interest rate reset happens during your loan period, the lesser would be your EMI increase. This is because principal outstanding keeps diminishing as your repay the loan.) You too can calculate the EMI pertaining to any interest rate, loan amount and repayment period by using the formula PMT(interest rate per month, remaining loan period in months, principal outstanding on your loan amount)
To ensure that your EMI never increases above your target amount (in our example that would be Rs 30,000) what you need to calculate is NOT how much loan you are “eligible”, but how much you can “afford”. You can compute your “affordable” loan amount by assuming a worst case interest rate of 14% p.a. (i.e. 1.16% per month) instead of the current market rate of interest of 9% p.a. The formula PV(1.16%, 240, 30000) gives you the loan amount that you can safely and comfortably “afford”- Rs 24.12 lacs. See how different it is from your “eligible” loan amount of Rs 33.34 lacs! That’s the effect of margin of safety!
Buying a home is a big financial commitment. It’s better to be safe and buy one you can really afford, instead of stretching yourself and facing the risk of Damocles’ sword.
As residents in a high growth developing economy, we need to be prepared to face high interest rates from time to time – thanks to inflation!. The downside of high interest rates is that loans become more expensive. Now we all know who bears the major brunt of this. The homeowners of course – because of 3 reasons: 1) among individuals, home owners typically take the largest quantum of loan 2) among retail loans, home loans have maximum tenure – 20 years on average 3) most home loans in India are variable rate loans; even the banks that do offer fixed rate loans build-in a reset clause which allows interest rate on the loan to be increased in the event of a spike in prevailing rates.
If rise in interest rate is inevitable, the only way to deal with it is to prepare for it, before you purchase your home. Once you make the purchase decision, you will most probably lock yourself into a loan whose repayment is going to consume a good portion of your earning life.
The Margin of Safety Principle
A commonsense approach to prepare for future increase in your home loan interest rate is to evaluate the worst-case scenario, and then build a margin of safety. If you examine how interest rates have moved over the past decade, you will notice that the maximum level of home loan interest rates during this period was around 14% p.a.. So it may be reasonable to assume that the worst-case scenario is home loan rates climbing back to 14% p.a. during the next decade. If it does, you would have two options: make higher EMI payments or settle for extending the tenure of your loan. Although the bank earns more interest income if you choose the latter, for the customer the former option is any day better. After all, why would you want to pay interest charges to the bank for extra years? And who knows -may be you want to take an early retirement – in which case you would be unable to extend the loan tenure.
The margin of safety question is - can you pay the higher EMI charges if your home loan interest rate increases to 14% p.a. from the current level of 9% p.a.? To know if you can, the first thing you need to do is calculate what would be the EMI amount at 14% p.a. interest rate. Then you need to decide if you can afford this higher EMI level “today”. You may counter my stance as being unnecessarily extra cautious, by arguing that even if an increase in EMI were to occur, it is likely to happen only at some point in the future - when your salary would have increased and you may be able to accommodate the EMI increase if any. I disagree. These days, most couples become homeowners at around the time they have their first kid. So even if their salaries increase, family expenses are also likely to increase. It is better to be sure upfront (at the time of purchasing your home) if you can afford a higher EMI in the event of an upward revision in interest rate on your home loan. This would save you from the agony of trying to make both ends meet when the event occurs.
If you are not sure you can meet the higher EMI commitment corresponding to the worst case scenario of 14% p.a. interest rate level, it may be better for you to settle for a smaller, less expensive home at the time of purchase. This way you can start with a smaller loan amount and lower EMI, leaving sufficient cushion (margin of safety) for potential increase in EMI at any point in the future.
Sample calculation using Microsoft Excel
Following is an example that will help you calculate the maximum loan amount you can “afford” after considering a margin of safety, which will protect you in the event of increase in interest rate.
Let’s say the maximum EMI you can afford is Rs 30,000. At current market rate of 9% p.a. for variable rate loans, this EMI commitment can make you “eligible” for a 20-year loan of Rs 33.34 lacs. You can calculate your loan eligibility in Excel by using the formula PV(interest rate per month, loan period in months, monthly payment). For our example that would be PV(0.75%, 240, 30000) = 33.34 lacs.
But a loan for Rs 33.34 lacs would leave you with no margin of safety if the interest rates were to rise further. e.g. If the interest rate is reset to 14% p.a immediately after you take the loan (the worst case scenario), your EMI would increase to Rs 41,463 – an amount that you may not be able to afford. (Note: The later the interest rate reset happens during your loan period, the lesser would be your EMI increase. This is because principal outstanding keeps diminishing as your repay the loan.) You too can calculate the EMI pertaining to any interest rate, loan amount and repayment period by using the formula PMT(interest rate per month, remaining loan period in months, principal outstanding on your loan amount)
To ensure that your EMI never increases above your target amount (in our example that would be Rs 30,000) what you need to calculate is NOT how much loan you are “eligible”, but how much you can “afford”. You can compute your “affordable” loan amount by assuming a worst case interest rate of 14% p.a. (i.e. 1.16% per month) instead of the current market rate of interest of 9% p.a. The formula PV(1.16%, 240, 30000) gives you the loan amount that you can safely and comfortably “afford”- Rs 24.12 lacs. See how different it is from your “eligible” loan amount of Rs 33.34 lacs! That’s the effect of margin of safety!
Buying a home is a big financial commitment. It’s better to be safe and buy one you can really afford, instead of stretching yourself and facing the risk of Damocles’ sword.
7 comments:
I am your fan ..
This is a great post and it has taught me something amazing .
Most of the people do invest in Real estate just because they are not able to see the dark side of it .. They do not want to consider the case when home prices crash and it turns out to be a asset that is a burden .. Just because prices are rising , they will invest in it without figuring out if they can really afford it . Same thing happens to Equity markets most of the case .
This is what i call other face of risk . People concentrate on their "willingness" to take risk , but never the "Ability" to take risk ..
My email is manish.pucsd@gmail.com
And I am a Financial Planner , I write at http://www.jagoinvestor.com
I would like to hear your views on this small study by me on "Equity returns in long term" : http://www.jagoinvestor.com/2009/10/4-charts-which-will-change-your.html
Manish
I am a regular reader and great of both of you Shyam & Manish !!!
Excellent article ... keep up the good work !!!
Thanks,
Asif
The concept of using future money came from west. I believe our previous generation were more happy in using the money what they had instead of spending the future money now( then take the pain of paying EMI's).
Aleast the westerners have social security from the govt during their sunset years, what do we here and fail to understand as why are we following the west in following the credit funding route.
sir when will u publish ur next article in ur site????????
we r waiting ur coming article....
Hi Manish - I appreciate the work that you are doing thru your website
Asif - thanks for the kind words
Guha - as usual a wise observation!
I read this in hindu.
Thanks for the home loans formulae , helps in my own decision making for home loans.
Any formula avbl for variable rates (annual step up increases of fixed rates of our banks) ?
thanks again for your timely help.
jambu.
"jambu.ganeshk@workmail.com"
Jambu - interest rates are hard to predict...so one cant really say what the interest rate on your variable rate loan is going to be 5 yrs form now. The best way to deal with this is to use the margin of safety method laid out in the article. Take a look at the maximum level interest rates reached during the last 10 yrs. Now see if the interest rates where to go back to those levels (14%-15% range) will you still be able to afford the EMI on your loan? That's the best planning you could do.
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