Maj Manish is a 30 year old officer and his family includes his wife (homemaker), 3 year old daughter, and retired parents. Manish had taken a home loan of Rs 25 lakhs one year back at 8.5% for 20 years with a monthly EMI of Rs. 21696. Apart from repaying the home loan, Manish’s other goals include planning for his daughter’s education, marriage and his own retirement. However, his entire planning is going haywire with his borrowing bank raising his Equated Monthly Instalments (EMIs) frequently ever since he has taken the loan. In one year the interest rate on Manish’s home loan has increased from 8.5% to 10%. The EMI has shot up from Rs 21,696 to Rs 24,043 and the outstanding balance is Rs 24.50 lakhs. Against the original total interest outgo of Rs 13,67,754, now the total interest outgo on the loan in the next 19 years will be Rs 17,59,484 even after paying the 1st year interest of Rs 2,08,892.
Just like Manish, lot of other people are facing the same problem due to the increase in their EMIs. So how can people like Manish tackle such situations? What are the options available to people like Manish?
Reason for rising interest rates
Since the last one year, in its monetary policy announcements, the RBI has been constantly increasing interest rates (Cash Reserve Ratio (CRR), Repo Rate and Reverse Repo Rate) in its battle against the inflation monster. All this has increased the borrowing costs for banks over a period of time. Initially banks were able to absorb the rate hikes and shield their customers against increased EMIs. But banks cannot absorb the rising costs of funds all the time. After initially resisting increasing interest rates, banks started passing the rate hikes to their customers by increasing the interest rates on floating rate loans. Since the last few months, customers have been feeling the pinch of increased rates in the form of higher EMIs on home loans, auto loans and other loans.
Pre-payment of Home Loans
Banks allow customers to pre-pay loans. Pre-payment helps the customer to reduce the outstanding amount and thereby reducing the interest burden and also finishing the loan earlier than its normal schedule. Pre-payment can be done in two ways: pre-paying a lumpsum amount at a time or increasing the EMI (5% or 10% or whatever % the customer is comfortable with). Let us explore the two options.
Pre-paying a Lump sum Amount
If the customer gets a onetime cash flow, he can use that to make a lumpsum pre-payment and reduce the outstanding balance on his home loan. For example, in case of Manish, if he has maturity proceeds from a bank fixed deposit (FD) or National Saving Certificates (NSC) or insurance maturity proceeds or for that matter, any lumpsum amount available to him, he can use this amount to make a pre-payment and reduce the outstanding amount on his home loan. By making a pre-payment the customer has 2 options:
• Reducing the loan tenure: The customer can make a lumpsum pre-payment and reduce the tenure of his home loan and keep the EMI the same. Let us see how this will work in Manish’s case. Let us assume that Manish gets a onetime cash flow of Rs 5 lakhs from the maturity of his National Savings Certificates (NSC). If he makes a pre-payment of Rs 5 lakhs, it will reduce his outstanding amount from Rs 24.50 lakhs to 19.50 lakhs. Manish can ask the bank to keep his EMI same at 24,043 and reduce the tenure of the loan. In such a scenario the tenure of Manish’s loan will reduce from 19 years (228 instalments) to 11 years (136 instalments). Manish’s instalments will get reduced by 92 instalments.
• Reducing the EMI: The customer can make a lumpsum pre-payment and reduce the EMI of his home loan and keep the tenure same. Let us see how this will work in Manish’s case. Let us assume that Manish gets a onetime cash flow of Rs 5 lakhs from the maturity of his National Savings Certificates (NSC). If he makes a pre-payment of Rs 5 lakhs, it will reduce his outstanding amount from Rs 24.50 lakhs to 19.50 lakhs. Manish can ask the bank to reduce the EMI on the loan and keep the tenure same at 19 years. In such a scenario the EMI on Manish’s loan will reduce from Rs 24,043 to Rs 19,137 and the tenure of the loan will remain same at 19 years.
Increasing the EMI by 5%
Every individual expects his salary to increase by at least 5% or 10% every year. So the person can use this increased cash flow to lighten his loan burden. Manish can ask his bank to increase his EMI by 5% compounded every year. In such a scenario, Manish’s current EMI will increase from Rs. 24,043 to Rs. 25,245 and subsequently go on further increasing by 5% every year. In such a scenario, Manish will be able to service his loan in 130 instalments (11 years) instead of 228 instalments (19 years) and reduce 98 EMIs. Some banks do not allow the customer to increase the EMI. In such a scenario Manish can take the difference between the increased EMI (Rs 25,245) and original EMI (Rs 24,043), i.e. Rs. 1202, and put it in a monthly recurring deposit. The customer can then use this money to make lumpsum pre-payment at the end of the year. The customer can follow this practice every year till the loan gets over.
Increasing the EMI by 10%
Manish also has the option to increase his EMI by 10%. In such a scenario Manish’s current EMI will increase from Rs 24,043 to Rs 26,447 and subsequently go on further increasing by 10% every year. In such a scenario Manish will be able to repay his remaining outstanding loan amount in 8 years (100 instalments) instead of 19 years and reduce 128 EMIs. If his bank does not allow this increase in EMI, Manish can take the difference between the increased EMI (Rs 26,447) and original EMI (Rs 24,043), i.e. Rs. 2404, and put it in a monthly recurring deposit to make lumpsum pre-payment at the end of the year.
Points to Remember:
While the customer can always make a partial lumpsum pre-payment or ask the bank to increase the EMI on his loan, there are few things that he should keep in mind. These include:
• A customer should not use money reserved for other goals like child education, marriage, retirement etc for pre-payment of home loan.
• When a customer asks the bank to increase the EMI by 5% or 10% every year, then he should make sure that he will be able to service the increased EMI. For example, if the customer increases his EMI by 10% compounded every year, then after few years the EMI may become substantially higher and the customer may find it difficult to service it.
• To make the article simple to explain the article assumes that there will be no further rate hikes in future. But in case of floating rate home loans the rates may increase or decrease depending on the market direction of interest rates. Once the interest rate changes, all the above calculations will change.
Conclusion
We have seen above how customers like Manish can service their home loan in a better manner. A customer can:
Make a partial lumpsum pre-payment and reduce the tenure of the loan and keep the EMI same OR
Make a partial lumpsum pre-payment and reduce the EMI of the loan and keep the tenure of the loan same OR
Increase the EMI on the loan by 5% or 10% or any percentage that he is comfortable with and finish the loan before its normal schedule OR
Use a combination of partial lumpsum pre-payment and also increase the EMI every year by a certain percentage and finish the loan before its normal schedule.
The above mentioned all options are very flexible in nature and customers can use them depending on how comfortable they are with each of them
Just like Manish, lot of other people are facing the same problem due to the increase in their EMIs. So how can people like Manish tackle such situations? What are the options available to people like Manish?
Reason for rising interest rates
Since the last one year, in its monetary policy announcements, the RBI has been constantly increasing interest rates (Cash Reserve Ratio (CRR), Repo Rate and Reverse Repo Rate) in its battle against the inflation monster. All this has increased the borrowing costs for banks over a period of time. Initially banks were able to absorb the rate hikes and shield their customers against increased EMIs. But banks cannot absorb the rising costs of funds all the time. After initially resisting increasing interest rates, banks started passing the rate hikes to their customers by increasing the interest rates on floating rate loans. Since the last few months, customers have been feeling the pinch of increased rates in the form of higher EMIs on home loans, auto loans and other loans.
Pre-payment of Home Loans
Banks allow customers to pre-pay loans. Pre-payment helps the customer to reduce the outstanding amount and thereby reducing the interest burden and also finishing the loan earlier than its normal schedule. Pre-payment can be done in two ways: pre-paying a lumpsum amount at a time or increasing the EMI (5% or 10% or whatever % the customer is comfortable with). Let us explore the two options.
Pre-paying a Lump sum Amount
If the customer gets a onetime cash flow, he can use that to make a lumpsum pre-payment and reduce the outstanding balance on his home loan. For example, in case of Manish, if he has maturity proceeds from a bank fixed deposit (FD) or National Saving Certificates (NSC) or insurance maturity proceeds or for that matter, any lumpsum amount available to him, he can use this amount to make a pre-payment and reduce the outstanding amount on his home loan. By making a pre-payment the customer has 2 options:
• Reducing the loan tenure: The customer can make a lumpsum pre-payment and reduce the tenure of his home loan and keep the EMI the same. Let us see how this will work in Manish’s case. Let us assume that Manish gets a onetime cash flow of Rs 5 lakhs from the maturity of his National Savings Certificates (NSC). If he makes a pre-payment of Rs 5 lakhs, it will reduce his outstanding amount from Rs 24.50 lakhs to 19.50 lakhs. Manish can ask the bank to keep his EMI same at 24,043 and reduce the tenure of the loan. In such a scenario the tenure of Manish’s loan will reduce from 19 years (228 instalments) to 11 years (136 instalments). Manish’s instalments will get reduced by 92 instalments.
• Reducing the EMI: The customer can make a lumpsum pre-payment and reduce the EMI of his home loan and keep the tenure same. Let us see how this will work in Manish’s case. Let us assume that Manish gets a onetime cash flow of Rs 5 lakhs from the maturity of his National Savings Certificates (NSC). If he makes a pre-payment of Rs 5 lakhs, it will reduce his outstanding amount from Rs 24.50 lakhs to 19.50 lakhs. Manish can ask the bank to reduce the EMI on the loan and keep the tenure same at 19 years. In such a scenario the EMI on Manish’s loan will reduce from Rs 24,043 to Rs 19,137 and the tenure of the loan will remain same at 19 years.
Increasing the EMI by 5%
Every individual expects his salary to increase by at least 5% or 10% every year. So the person can use this increased cash flow to lighten his loan burden. Manish can ask his bank to increase his EMI by 5% compounded every year. In such a scenario, Manish’s current EMI will increase from Rs. 24,043 to Rs. 25,245 and subsequently go on further increasing by 5% every year. In such a scenario, Manish will be able to service his loan in 130 instalments (11 years) instead of 228 instalments (19 years) and reduce 98 EMIs. Some banks do not allow the customer to increase the EMI. In such a scenario Manish can take the difference between the increased EMI (Rs 25,245) and original EMI (Rs 24,043), i.e. Rs. 1202, and put it in a monthly recurring deposit. The customer can then use this money to make lumpsum pre-payment at the end of the year. The customer can follow this practice every year till the loan gets over.
Increasing the EMI by 10%
Manish also has the option to increase his EMI by 10%. In such a scenario Manish’s current EMI will increase from Rs 24,043 to Rs 26,447 and subsequently go on further increasing by 10% every year. In such a scenario Manish will be able to repay his remaining outstanding loan amount in 8 years (100 instalments) instead of 19 years and reduce 128 EMIs. If his bank does not allow this increase in EMI, Manish can take the difference between the increased EMI (Rs 26,447) and original EMI (Rs 24,043), i.e. Rs. 2404, and put it in a monthly recurring deposit to make lumpsum pre-payment at the end of the year.
Points to Remember:
While the customer can always make a partial lumpsum pre-payment or ask the bank to increase the EMI on his loan, there are few things that he should keep in mind. These include:
• A customer should not use money reserved for other goals like child education, marriage, retirement etc for pre-payment of home loan.
• When a customer asks the bank to increase the EMI by 5% or 10% every year, then he should make sure that he will be able to service the increased EMI. For example, if the customer increases his EMI by 10% compounded every year, then after few years the EMI may become substantially higher and the customer may find it difficult to service it.
• To make the article simple to explain the article assumes that there will be no further rate hikes in future. But in case of floating rate home loans the rates may increase or decrease depending on the market direction of interest rates. Once the interest rate changes, all the above calculations will change.
Conclusion
We have seen above how customers like Manish can service their home loan in a better manner. A customer can:
Make a partial lumpsum pre-payment and reduce the tenure of the loan and keep the EMI same OR
Make a partial lumpsum pre-payment and reduce the EMI of the loan and keep the tenure of the loan same OR
Increase the EMI on the loan by 5% or 10% or any percentage that he is comfortable with and finish the loan before its normal schedule OR
Use a combination of partial lumpsum pre-payment and also increase the EMI every year by a certain percentage and finish the loan before its normal schedule.
The above mentioned all options are very flexible in nature and customers can use them depending on how comfortable they are with each of them
