In this article, we shall explore the various steps a first time home buyer goes through, and the considerations one should pay attention to, while looking at a home loan to buy your dream home.
Home loans are given by banks to the employed or self-employed people who can show evidence of a continuous income inflow over a period of time, and have a good credit score with the Indian credit bureau (CIBIL). Of course, the banks charge a rate of interest while lending money as a ‘home loan’. This interest element is slightly higher for self-employed persons compared to salaried folks.
The ‘security’ the banks takes is the home itself which is mortgaged to the lender (the bank) which keeps the title of the property with itself till the debt is paid off completely (with interest) by the borrower.
Home buyers could take home loans for purchase of an apartment or house or even for renovation purposes. The banks ascertain the repayment capacity prior to sanctioning the loan, besides the cost (or worth) of the property. A certain formula is applied by the banks to ensure that the person(s) taking a home loan does not stretch beyond reasonable means, and should be able to repay the loan without defaulting on the instalments. The repayment is staggered over a period of anything between 10 to 30 years depending upon the age of the loan seeker. The repayments are done usually in ‘Equated Monthly Instalments’ which are governed by the rate of interest, and the tenure. The bank disburses the loans directly to the builder on builder, unless the person takes the loan for making a home on a residential plot. For apartments, the disbursement of loans depends on the builders too. The disbursement of loan amount could be a ‘time linked plan’, a ‘construction linked plan’ or a ‘subvention scheme’.
It is usually observed that while people take loans for a longer period, most of the people pay-off their loans in about 10 years on an average. Reserve bank of India (RBI) has mandated that no penalty should be charged to the borrower should one want to prepay (partial prepayment) or foreclose (full payment) of the loan taken on a ‘floating rate’. However, banks may charge a penalty on prepayment of a loan taken on ‘fixed home’ loan rate.
The home loan process is very convenient and quick since the banks are constantly in competition with one another to grab customers with a good financial standing. Separately, the risk to banks is relatively minimal owing to the mortgage factor where the bank has a right on the property unless the debt is fully paid off by the borrower.
Some facts about home loans and borrowers
Home loans are the only way for most people to afford a home for their family. Not many people usually have the full lump sum amount readily available to pay upfront for the apartment or house they want to purchase. Plus, ‘servicing a loan’ (i.e. repaying) with an ‘Equated Monthly Instalment’ (EMI) to the extent of 50% or 60% of their monthly income inflow is something people in their 30’s and 40’s opt for. This may also happen because of the dual-income factor (both spouses earning), and their ability to collectively repay the loan becomes a formidable plus point.
One of the reasons people take long term loan period initially is because shorter periods (tenure) can deplete their immediate needs in the early years of their career. Younger couples start their career, and eventually grow up in the hierarchy with ambitions such as brining up their children in the best possible manner, achieving higher social and financial status, and being fiercely competitive in their jobs. Such households wait for a few years till their income exceeds the threshold where they are able to save more, and are able to make prepayments, or even foreclose their home loans.
Those with fat salaries in absolute terms are able to withstand higher outflow of EMIs with shorter tenures right up front.
For example, a person with a monthly net salary of Rs 50,000 may not be able to afford to pay 60% of one’s income in EMIs, whereas, a person with a monthly take-home income of Rs 1.5 lacs or more would be able to afford a higher outflow of EMIs with relative ease.
While taking on an obligation of a Equated Monthly Instalment (EMI) of a home loan, it is important for a new home buyer not to stretch beyond reasonable means. As a new home buyer, we must account for uncertainties that are not be immediately foreseeable. Threats come unannounced just like it happened during the global recession of 2008, and the ongoing pandemic of 2020. Millions have lost jobs during bad times, and economies have taken an unkind, unexpected downturn impacting populations across the globe. During such times, even if the governments or banks give a moratorium period for repayment of loans, they sure cannot guarantee a turnaround in our personal financial situation. We have to eventually pay-up for the loans taken, and only money (sustainable income) can do the magic for you!
Hence, although risk-taking and boldness may be good at times, one should exercise caution and take a calculated risk. With unpredictable economic conditions, competition, and all pervasive uncertainty, one needs to have adequate safety nets before over-leveraging oneself with a home loan.
Steps to take while seeking a home loan
First Step: check your personal finances & future capabilities, your home loan eligibility, and various EMI options along with varying repayment tenures
Some people opt for the longest tenure to minimize the EMI burden, and maximize on their loan eligibility i.e. the maximum amount they can get a loan for. This strategy offers the advantage of a ‘lower initial EMI’, but also means you end up paying a very high amount of interest component in the long run.
However, this does not mean that this strategy is a necessarily wrong. Those who are in their late 20s and early 30s, and are highly skilled and qualified, can safely choose this option. Their skill and capabilities takes them places besides offering exponential increase in their incomes or salaries. For this category of people, this option could make complete sense, since these people are eventually able to foreclose loans within 8 to 10 years, and also own fabulous properties.
However, it is important not to risk your peace when you are not certain about this. Taking such risks is alright for those who are exceptionally talented, hardworking, fiercely competitive, or hail from top professional colleges (top IITs, IIITs, IIMs, CA, AIIMS etc.), and their skills/profession is in demand (with high growth potential), not otherwise.
TWO Scenario Example to understand home loans, EMIs, tenure, and ‘principal’ and ‘interest’ we repay
Let us understand this with an example of TWO SCENARIOS, i.e. ‘30 year tenure’ versus a ‘20 year tenure’ scenario for repayment of INR 30 lacs of home loan.
Let us see what happens when we take a home loan of INR 30 lacs. In the 30 year tenure scenario, you end up paying 28% more than what you pay in a 20 year tenure scenario. We shall also check out how much we end up paying in about 10 years’ time, i.e. a status check in year 10, as we go with either of these two tenures (30 and 20 years).
Let us compare both scenario 1 (30 years tenure) & scenario 2 (20 years tenure)-
Scenario ONE: tenure of 30 years, 57% (INR 40.04 lacs) paid back as INTEREST!
For a home loan of INR 30 lacs at 6.75% interest rate, and a tenure of 30 years, the EMI works out INR 19458 per month
Over a period of 30 years, you end up paying back INR 70,04,860 which comprises of INR 30 lacs of principal amount and an interest amount of INR 40.04 lacs.
Let’s see how much you shall be paying back as EMIs in the first 10 years: In the first 10 years, you shall have paid a total amount of INR 23.43 lacs of EMIs. Out of this total, you shall have paid back INR 4.40 lacs of principal amount, and a whopping INR 18.93 lacs of interest element in the first 10 years.
What is the inference you draw from the 10 year status-check? This means that the amortization schedule for the first few years is all about taking back the interest element from you, and when you foreclose the amount within the first 8 to 10 years, you are actually paying an extremely heavy interest component.
Scenario TWO: tenure of 20 years, 45% (INR 24.74 lacs) paid back as INTEREST!
For a home loan of INR 30 lacs at 6.75% interest rate, and a tenure of 20 years, the EMI works out INR 22811 per month
Over a period of 30 years, you end up paying back INR 54,74,619 which comprises of INR 30 lacs of principal amount and an interest amount of INR 24.74 lacs.
Let’s see how much you shall be paying back as EMIs in the first 10 years: In the first 10 years, you shall have paid a total amount of INR 27.37 lacs of EMIs. Out of this total, you shall have paid back INR 10.13 lacs of principal amount, and INR 17.23 lacs of interest element in the first 10 years. Clearly, you end up repaying more of principal amount with a lower tenure of 20 years, which is good for you.
The Learning? A new home buyer must take a good hard look at the amortization table/schedule, and see how much of interest is being paid in the first half of the home loan tenure. You must further explore the options by carefully checking the amortization schedule using any home loan calculators of Indian banks readily available on the internet.
The key message: Only if you are hopeful of reducing the tenure from 30 years to under 20 years, and have the capability of saving enough for prepayment you should consider longer terms like 30 years, not otherwise. Of course, there are exceptions, and these are only generic recommendations for indicative guidance and understanding.
The primary recommendation is to make sure you do not get trapped in uncertainty by stretching beyond your capabilities and means. You must also bear in mind that economic conditions and times can become uncertain anytime. Even health factor can play the spoilsport, hence, it is wise to tread cautiously before committing to an EMI.
The right decision is one where you can strike the right balance with the following:
- Choose an EMI that you can afford comfortably
- The EMI should be below 60% of your average or net ‘take home income’
- Do evaluate all the EMI options and tenured by keeping your ‘age’ and ‘potential to earn’ a sustainable income in the years ahead
- Besides your income from salary or business, you must also ‘include your income from other sources’, which help increase your loan eligibility as well
- Should you have your spouse or other immediate family members earning, you may include them as co-applicants to your home loan application, which helps increase your eligibility of loan amount
Second Step: To ensure the legal status of the property is clear which includes going for a RERA registered property, and duly approved for home loans by major banks
- The seller or builder must have all the legal documents in place especially RERA registration and permission by civic authorities like GHMC (which grants ‘Building permission’). This also ensures that the property is legally safe. Other legal documents like ‘commencement certificate’ are critical
- For ‘ready to move in’ properties, the ‘Occupation certificate’ is a critical document for banks to sanction loans
- For construction of home/house on a residential plot, all the papers must be in order to obtain a home loan. Certain banks are fine with giving loans upto 150% of the ‘registered amount’ coupled with the property loan amount being around 75% of the ‘market value’
- Certain banks put a restriction of offering upto 75% loan on the amount at which it is registered, or up to 75% of the market value, whichever is lower
- A home loan seeker must ensure that the property is in a recognized/approved area which has been sanctioned for home loan. Areas unapproved by civic authorities or located in ‘Gram Panchayats’ are to be avoided
Third Step: Choose your interest rate option wisely- Floating or Fixed rate
- In the current COVID-19 times, the interest rates are at an all-time low, hence it is recommended to go with ‘floating interest rates’, since the rates could lower further, or remain/fluctuate at lower levels
- Plus, floating rates are not only variable, but there is ‘no additional prepayment charges’ to be paid to the bank with these rates when trying to reduce the principal component of your home loan
- Those who do not want any fluctuations in their monthly outflow opt for ‘fixed interest rates’. These fixed charges, however, may charge a higher interest rate besides the penalty charge for any prepayment done
- Besides, these ‘fixed rate’ offered by certain banks tend to move back to floating rates post a certain ‘initial offering period’. Hence, one must also check the duration of this so called ‘fixed rate’, since it could only be an ‘initial incentive’ to choose a certain bank’s home loan offering. Once the extremely low ‘fixed rates’ are converted into variable rates, then one may witness sharp increase in interest rates, and the tenure or EMI may get adversely impacted for the home loan seeker
Fourth Step: Carefully consider the home loan foreclosure charges and prepayment related charges or guidelines
- Even for those who opt for a home loan for 30 years, people usually tend to foreclose the home loan in about 8 to 10 years to fully own their dream home. Hence, one needs to know the prepayment rules/guidelines regarding prepayment like how many times a person can make partial prepayments in a year, and what are the foreclosure charges, if any
- It is advisable to use your yearly bonuses or savings to pay off the home loan, and reduce the principal amount as and when possible. One can even reduce the tenure, thereby increasing the payout of principal amount with each EMI. Some people focus on saving a lump sum amount periodically, and hit on the principal amount a few times every year. This means, you could prepay a part of the loan each year, and reduce the principal amount considerably with a regulated and well-planned approach
- Thus, it is good to have a bank that allows you this flexibility to prepay with ease, and not obstruct your efforts to reduce your loan burden
- There are certain banks where you have ‘home credit’ or ‘home saver’ or ‘max gain’ options, which give you the provision of depositing your surplus savings in the such a ‘home credit’ bank account which is used to offset the interest element of your home loan taken from the same bank. The best part is that you pay ‘interest’ only in the difference amount between what you deposit vis-à-vis the home loan amount. It gives you the benefits of prepayment without having to compromise on the liquidity of your money. To put it in other words, the interest for the month is calculated based on the ‘Home Loan account’ minus the ‘Excess Surplus money account’. For instance, if you have a loan amount of INR 30 lacs, and you have excess funds lying in your ‘home saver account’, then the interest for the month will be charged on [INR 30 lacs – INR 5 lacs = INR 25 lacs)
Fifth Step: Select the bank that suits your requirement and works well for you
- Besides rate of interest, you must look at the customer convenience factors like ability to get all the information you need in a timely manner, be it details about your loan account, or certificates for your Income Tax purposes, flexibilities around prepayment, access to their physical office and call center, the customer service support, and their overall commitment to customer satisfaction
- One should also check reviews from friends and peers who have availed of bank services for home loans, and the extent to which the bank is professionally equipped to handle your home loan account details without errors that may impact you financially or otherwise
- A bank changing ‘base rates’ too often is indicative of inconvenience to your overall prepayment plans. You may also want to check if the bank is willing to pass on the benefits of lower rates to her customers. Base rate is the lending rate of a home loan, and is calculated based on the ‘cost of funds’
- Compare the offers of different banks, and be aware that the lowest offer need not necessarily be the best in light of all the points explained above. Compare the interest rates, the loan servicing record of the banks, the reviews by customers, the guidelines for floating and fixed interest rates, the guidelines for prepayment, flexibilities like ‘home saver options’, and the overall customer friendliness index before choosing a bank for your home loan
The most important thing about taking a home loan is to gain a good understanding of what we are getting into. We need to exercise caution, take a well informed decision, and a well-calculated risk while choosing the ‘total amount’ we take as a home loan, choosing an ‘EMI’, or even while choosing a ‘tenure’ to make repayments.
An understanding of how ‘amortization schedule’ works, and how the ‘interest’ amount and the ‘principal’ amount is paid back to the bank over a certain tenure are important considerations for a home buyer. This enables the home buyer in seeking the right amount of home loan, and also in planning prepayments or a foreclosure. On the more practical side, assessment of the record of the bank as a lender is critical. One needs to know how the bank works, their priorities, their customer centricity measures, and their overall modus-operandi. The elements that govern the ‘values’ of a lending institution are perhaps much more important than the ‘interest rates’ being offered.
Each individual (borrower) must account for the uncertainties that the world offers, and not stretch beyond reasonable means while seeking a home loan. A fine balance between ‘risk-taking’ and ‘financial prudence’ must be established! After all, a human life is not just about being enslaved by tormenting EMIs that are a result of an ill-conceived financial planning and poor decision making.
Clearly, ‘sound judgment’ and ‘well-informed decisions’ do not happen easily! Albeit, one must take calculated risks backed by adequate knowledge, financial wisdom, and the quintessential human zest of leading a fine, well-balanced & meaningful life!
Therefore, a home buyer must educate oneself, gather the required information, and take some time while evaluating the home loan options to buy a property.
To quote Louis Pasteur: “Chance favours the prepared mind, and opportunity favours the bold”