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| Beware teaser rates |
| AMAR PANDIT / Mumbai Feb 07, 2010, 00:21 IST |
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Do not base your decision on the home loan rate, but on your income stream and your ability to pay back.
The Reserve Bank of India (RBI) recently cautioned banks on teaser home loan rates, saying the margin rates for such loans should be 30-35 per cent. RBI is concerned that teaser loan rates could lead to an increase in defaults on home loans, as was witnessed in 2007 and 2008 when interest rates were going up. The concern is well reasoned, as the start of the crack of the US financial system is clearly attributed to the default in home loan rates by borrowers when the rates went up.
A teaser rate is a low, initial home loan interest rate that generally continues for the first few years and then would go up over time. These schemes have a fixed rate, between 8-8.5 per cent, for the first 2-3 years of its tenure; they turn into market-linked floating rates soon after. I can see why RBI is concerned. There are three important levers in any real estate transaction: price, interest rates and changes in income. Most bull runs in real estate are based on all the three levers remaining low. In 2003, prices and interest rates together were extremely low and incomes were going up and one saw a bull run in real estate actually picking up in 2005 because of these factors. Today, prices are crazy , incomes are not going up, but interest rates are low. So, teaser home loan rates are enticing people to borrow, with the belief that incomes would go up in the next few years and so would prices.
Very few people have thought on:
- What would happen if the prices went down?
- What if interest rates went up at the same time but incomes did not go up substantially?
The answer to both the questions could mean that the bank can come back to a borrower and ask for more margin money. Take an example: You are enticed by a teaser loan rate and you buy a property worth Rs 1 crore by making a down payment of Rs 15 lakh (15 per cent). Let’s say the real estate market corrects by 40 per cent, which is completely possible. At this point, a bank can invoke the Depreciation of Security clause in a home loan agreement and get the person to pay an upfront amount. This is because the market value of the property is Rs 60 lakh now and the bank’s exposure should just be 85 per cent of Rs 60 lakh, or Rs 51 lakh. But, the bank has lent you Rs 85 lakh and so, you must now pay them Rs 85 lakh minus Rs 51 lakh immediately. If you do not pay, you become a defaulter, even though you are paying equated monthly installments (EMIs) on time. And, the entire loan becomes payable immediately.
Similarly, if interest rates go up after a few years, so do your EMIs. If rates go up by 2-3 per cent, the impact on your home loan can be huge, first in the form of your tenure going up and then the EMIs (if increase in tenure is not possible). Hence, RBI wants banks to demand a higher margin amount, of 30-35 per cent of the total value, from borrowers who avail teaser rates. This is to ensure that only sound borrowers are able to do so. The impact of interest rate hike on such borrowers would be low.
I personally believe a person should buy a house if he needs it and if prices are affordable. A person should not buy a house because interest rates are low. One should buy a house if rates are affordable even if the interest rates are high. However, if rates are low and even zero initially, but you buy a house you cannot afford, what do you think would be the outcome? At some point, there is a strong likelihood of default. The point is, do not worry about low or high interest rates. Worry about affordability of the house and the kind of borrowing you are undertaking.
If you are planning to buy because of a low interest rate offered to you, chances are it is not a smart decision. Take a critical look of your cash flows, other borrowings, other investments, income growth in the next three years and restrict your EMI to 35-40 per cent of your post-tax income (exclude bonus and variable payments while calculating this). If you restrict your EMI to a percentage like this, an increase in home loan rates will not have a major impact on your financial situation.
There were plenty of horrific stories of suicides because of an inability to pay home loans, not just in the US but also in India. Considering the current state of the real estate market, it is safer to borrow only if you can afford the house and not because interest rates are low.
The writer is director, My Financial Advisor
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