Understanding interest rates and its impact on home buying decision!

Buying a home has always been a cherished dream for an individual. The very thought of staying within the four walls that belong to you is very enthralling. The home that one owns provides not only the physical comfort but also emotional and psychological security which, in turn facilitate peace in life.

The dream of purchasing a home has remained intact; what has changed over the years though is age profile of buyers. Not long ago, purchasing a home would be a reality when a middle class man is on the verge of retirement. His life- long saving could be barely enough to finance the coveted asset. The balance could be pooled in by relatives and friends.  However, the time has changed now. Thanks to the wave of financial reforms and robust banking sector today. A young man out from the college and grabbing a promising job will soon be found to survey the real estate market to book a house.

The relationship between the financial sector and real estate today is complementary in nature even though the banks may be viewed as having upper hand in terms of being fund providers. It would not be an exaggeration to assume that majority of the transactions in the real estate market in India is being financed by bank loans. In such situations where bank loans have gained so much of importance in our lives, it becomes a necessity to understand the nuances attached with them.

Interest Rate:

A home loan seeker is confronted with a myriad of jargon. The most common and yet the most critical among them all is interest rate. Understanding interest rate and impact of its movement on the loan amount is crucial in making an informed decision.

Interest, to put it simply, is a kind of fee charged by lender of funds from the borrower. This fee or the interest may be computed at a “fixed” or “variable/floating” rate. So, if Rahul takes a loan of Rs. One Lac from a bank for period of one year at a rate of interest of 10%, it means he needs to refund Rs.1, 10,000/- at the expiry of one year (Rs. One Lac is the principal amount and Rs.10, 000/- is the interest).

Eligibility to avail home loans:

Banks and Housing Finance Companies are cautious when they lend. There are certain prudential norms which they follow while sanctioning a home loan. One of them is that the bank would restrict its exposure up to 80% of the value of the asset in respect of residential house property subject to the eligibility of the buyer. How the eligibility is determined and what role level of interest rate plays are interesting aspects to discuss.

In a typical home loan application, a bank would consider the following while determining the maximum amount of loan that can be sanctioned:

  1. Gross Salary/month
  2. Net Salary/month
  3. Value of property 

An example:

Let’s take an illustration. Amit, a young software engineer in his mid twenties wishes to buy a house in Delhi NCR. He zeroes in on a property in Noida. The description of property is as follows:

  • Builder: Sky Builder
  • Area of Flat: 1000 Sq. Feet
  • Rate/Sq. Feet (All inclusive): Rs.5000/-
  • Payment Plan: Construction linked 
  • Construction Period: 2 years 

Equipped with such information, the bank would put a threshold limit of Rs.40 Lac (Rs.50 Lac X 80%) on the loan amount that can be sanctioned against the property. Now it needs to evaluate eligibility of Amit based on his income profile. Banks make such evaluation on the basis of their own criteria which may differ from bank to bank. However, as a general rule, banks consider around 40-45% of net salary of an individual to be needed to service EMI.

The following example shows eligibility of Amit in three interest rates scenarios.  It has been assumed that in all three situations, Amit’s salary remains same and there is no change in any variable except in interest rate. In situation-I, where the interest rate is 10.50%p.a., Amit’s loan eligibility works out to be Rs.40 Lac. This is a perfect situation for him as he needs Rs.40 lac only and the maximum amount that the bank is ready to disburse is also Rs.40 lac. However, the situation is not so comfortable when there is a spike in the interest rate from 10.50% to 11.50% p.a. (situation-III).  Keeping the EMI amount almost at same level, there is a decline in the loan eligibility amount to the extent of Rs.2.55 Lac. The reason is simple. Given the hike in the interest rates and no corresponding increase in the income level of the individual, the banks would like to maintain their risk exposure at existing level. Hence, there is a reduction in the loan amount. A decline in the interest rates would be a spurt for the banks to increase the loan eligibility. This however is subject to overall ceiling with respect to asset value.

EMI:

Interest rate movements also cause substantial variability in the EMI that we pay. The table below is quite self-explanatory:

Hope this time when news channels flash the story of how RBI Governor is contemplating to tinker with the interest rates in its monetary policy review, you would not be so clueless about its probable impact on your home loan.  So watch out for it with the analyst in you.