No silver lining

With interest rates going up, there are more disadvantages than gains when a borrower goes in for a 30-year repayment tenure

Although a majority in the media have spoken well of the newly emerging 30-year home loan tenure for borrowers, several finance experts also feel such an outright admiration is at once impulsive, and perhaps it is too pre-mature to either condemn it or even say it is rewarding.

But it does have its fallouts, and we bring the pros and cons of the latest offer after a thorough study that would help home loan borrowers think and decide.

While the cultural wisdom in our country preaches ‘limit your spending to your earnings’ and availing oneself of a loan is still a taboo, SBI, the largest bank, is trying to entice home loan seekers with higher loan amount beyond their repayment capacity. It has announced increasing the loan term from 20 years to 30 years. The trend, likely to be followed by other banks and HFCs (Home Finance Companies), may lead to ‘sub-prime’ kind of crisis, which recently rattled not only the U.S., but crippled the entire global economy.

The rate of interest on home loan is increasing at a faster rate and has peaked to 11.5-12 per cent at present, against 8-9 per cent about three years ago.

As and when interest rate hike was effected, most banks and HFCs went on increasing the tenure keeping the EMIs intact, in view of the fact that the income of borrowers has not increased substantially to afford increased EMIs.

Since increased EMIs would become a burden , recently the Finance Ministry advised all banks to increase the tenure but keep the same EMI for existing borrowers.

It seems SBI has not only increased the loan tenure for existing borrowers, but for fresh loan seekers also.

Let us analyse whether extending the loan term to 30 years is good as reported in some section of the media. Advantages

a. Higher loan eligibility

Since historically property prices have remained very high (as high as 8-10 times of annual income), vast majority of people look for higher loan amount. If the repayment period is longer, the loan eligibility is higher.

Normally banks or HFCs arrive at loan eligibility by considering 40-50 per cent of applicant’s income as repayment capacity. If other loans exist, the repayment instalment of those loans would be deducted to arrive at the EMI to be fixed for the intended home loan.

Let us take the example of Murthy, a 30-year-old government employee, whose income is Rs. 40,000 per month and who has no other liabilities. Considering the repayment capacity as 50 per cent, his EMI could be limited to Rs. 20,000. If the interest rate is 10 per cent for 20 years, he would be eligible for a loan of Rs. 20.75 lakh and the EMI could be Rs. 20,025. In such a case, in 20 years, he would end up paying total interest of Rs. 27.30 lakh.

If a bank/HFC offers him a 30-year loan, his eligibility increases to Rs. 23 lakh, at similar EMI of Rs. 20,185. This results in an increase in loan eligibility by Rs. 2.25 lakh, which works out to 10.8 per cent increase compared to 20-year loan.

b. Lower EMI

The longer the term, the lesser is the EMI. If Mr. Murthy opts for Rs. 20.75 lakh with 30-year loan, the EMI reduces to Rs. 18,210, as against the EMI of Rs. 20,025 for a 20-year loan. The reduction in EMI is Rs. 1,815 pm, which works out to nine per cent.

Thus, one can get 10 per cent more loan or can get the advantage of lower EMI, by opting for a 30-year loan.

c. Immediate relief for existing borrowers

Increasing the term by keeping the same EMI may help the existing borrowers immediately. Suppose Mr. Murthy had taken a home loan of Rs. 20 lakh at nine per cent interest for a 20-year term in 2009.

His EMI would have been Rs. 17,995. Now after 24 months, if interest rate is increased to 11 per cent, his EMI increases to Rs. 20,466.

If Mr. Murthy finds it difficult to pay higher EMIs and the bank is agreeable to retaining the same EMI by increasing the term, the remaining term of 18 years would increase to 35 years!

In such a case the new EMI would be Rs. 18,005. In 37 years (lifelong debt), he would end up paying interest of Rs. 60 lakh! (three times the loan availed).

Disadvantages of 30-year loans

a. The burden of higher loan eligibility

In the above illustration of Mr. Murthy, who was getting benefit of 10.8 per cent more loan (from 20.75 lakh to Rs. 23 lakh), he would not only be debt-ridden for 10 more years, but also end up paying total interest of Rs. 49.65 lakh in 30 years!

Just for an increased loan of Rs. 2.25 lakh, Mr. Murthy ends up paying extra interest to the tune of Rs. 22.35 lakhs.

b. The aftermath of lower EMI

For a loan of Rs. 20.75 lakh at 10 per cent interest, for a 20-year term, the total interest payable is Rs. 27.30 lakh. If Murthy opts for a Rs. 20.75 lakh loan for a 30-year term, just to save Rs. 1,815 pm, not only he is debt-ridden for 10 more years, he ends up paying total interest of Rs. 44.8 lakh in 30 years.

Thus there are no real advantages of very long term loans (beyond 15-20 years), but multiple disadvantages.

Since the interest earned is income for lenders, such 30-year loans would immensely help to increase their profits by huge margins, with less administrative costs, by serving lesser customers.

On the other hand, loans beyond 15-20 years pose higher credit risk for lenders, as the uncertainty of the income of borrowers increases and depreciation of house property in the long run erodes its commercial value.

Such a scenario would result in higher NPAs (Non-Performing Assets) i.e. bad loans. Increasing the tenure to 30 years will pose a bigger threat to lenders in the form of mismatch between assets and liabilities.

Since lenders have access to only short-term liabilities (fixed deposits, term loans etc.), lending such amounts to 30-year loans will surely strain the asset-liability management. Hence it is highly recommended to avoid loans beyond 20 years. If higher EMI is a burden , it may be inevitable for you to opt for loans beyond 20 years.

It is true that 30-year loans are popular in the U.S. and other so-called advanced economies, because there, the interest rates have been hovering at less than five per cent pa since ages.

r.p.deshpande

(The author is Director, Institute of Home Finance, and can be contacted at deshpanderp2007@gmail.com)