Home loan strategy

Buying a house, by itself, is a big decision. And after that deciding on the bank, whether to take a fixed or floating rate and all the documentation is definitely going to exhaust you completely. But this is just the beginning.

Now comes the painful part of constantly monitoring the rates, whether they are rising or falling. This is because there could be opportunities where the rate of interest that you are paying to the bank could be higher than the rate that is being offered to the new borrowers.

A typical case of wives versus girlfriends where a girlfriend (read a new borrower) is treated with extra caution and wife (read an old borrower) is taken for granted. So, when the rates go up, a new borrower is subsidised by hiking the spread for the old borrower. And when they go down, banks are often reluctant to cut it for the existing customers. The advantage always goes to the new ones.

Confused? Here is how it works. Most banks have a mortgage specific rate. Popularly known as the rack rate, banks use this as the benchmark, based on which, your home loan rate is calculated. They charge you something known as a "spread" which is 3 per cent to 4 per cent below the rack rate.

While for the new customer, this "spread" is 4 per cent, the old customers have to pay a lower spread, say 3 per cent. But a lower spread means a higher rate of interest. How this works is as follows. If the rack rate is 15 per cent, new loan seekers pay an interest of say, 11 per cent (4 per cent below the rack rate) and old customers continue to pay at 12 per cent (3 per cent below the rack rate).

Obviously, this can put the existing customer at a disadvantage because his interest payout is higher. And despite being a customer on floating rate, you do not get the benefit of lower rates.

However, the existing customer has an option. He can always ask for adjustment of his rate to a new level if the interest rates have come down. This is called re-adjustment of rate or spread that he is currently paying. For example, you were offered a spread of 3 per cent when you took the loan, and later, the rate falls, you can go ahead and negotiate a better spread of 3.5 per cent or 4 per cent depending on the market reality at that time.

For example, if you have taken a home loan of Rs 50 lakh for 20 years at 12 per cent interest rate, the numbers work out something like this. If in the first year, the rate gets reduced for the new customer at 11 per cent, then it makes sense to align it. And you get a benefit of Rs 2,81,270 (See Benefits of realignment). The same goes for changing it after five years as well.

However, if the rate difference is below 1 per cent in any case, it does not make sense to align. The table shows that aligning it after five years to 11.75 per cent that is, a 25 basis point fall makes you lose money because of the 2 per cent charge. Similar exercises for changing after five years when there is a 50 basis point drop gives you a small benefit of Rs 9,067. In other words, realignment is important but is not always beneficial.

Financial experts are of the view that the rate difference should be at least 1 to 2 per cent for you to get some advantage of readjustment. Says Harsh Roongta, CEO, www.apnaloan.com, “It is important to review the rates every six months.”

Accordingly, one can take a call whether to adjust the rates or not. However, it is important that in the initial years, you keep a careful watch on the rates. This is because a rate differential of one per cent does make a big difference in your interest pay out. Of course, it is also dependent on the fee that the bank is charging to shift your existing rate. A lower fee would encourage home loan seekers to adjust it more often.

It is important to remember that buying a home is one of the largest expenses that you will ever make. And, to reduce the interest payout, it is important to constantly monitor where the rates are heading.

Via Business Standard