Basics of Personal Finance Course – Week 4 of 4

Welcome to Week 4 of the 1-Month course “Basics of Personal Finance”. This is the final week of the course.

Last week, we learnt about Life Insurance. This week, let’s focus on Loans.

Home Loans – Factors to consider

Let’s discuss what factors you should consider when you are taking a home loan.

Remember: Although some factors (like interest rate) are more important than others (like freebies offered), you should look at all the factors before finalizing the home loan provider.

Rate of Interest

This is the single biggest factor while taking a home loan. The lower the interest rate, the better it is. This is because if the rate of interest is less, you would pay less every month towards interest, and pay more every month towards principle.

A lower interest rate also obviously reduces the monthly payout or the EMI. A lower EMI is easier to repay.

Lower interest rate also means that you would be eligible for a higher loan amount for a given income level.

Also remember that the interest rate is higher in case of fixed rate loans compared to floating rate loans.

Bottomline: Go in for a bank that offers a lower interest rate.

Type of interest rate – Fixed / Floating

You need to check if the bank you are considering offers the type of interest rate that you want. All banks offer floating interest rate, but these days, many banks do not offer fixed interest rate.

(More information follows about choosing between fixed and floating interest)

Bottomline: Go in for a bank that offers the type of interest rate you want.

Tenure

Check the tenure for which the bank offers the loan – most banks offer home loans for upto 20 years, but some banks also offer home loans for 25 years.

A longer tenure means that the EMI would be smaller, and you would be eligible for a higher loan amount.

But longer tenure also means that you would end up paying more in the form of interest over the life of the loan.

So, balance these two according to your needs, and decide on the tenure.

Bottomline: If you decide on a tenure upto 20 years, any bank should be fine. But if you want a loan for more than 20 years, do check if the bank you are considering offers it.

Down Payment / Percentage of amount given as loan

Every bank asks for a certain percentage of the loan as down payment. This down payment used to be as low as 0% in special cases – for example, if a builder had tied up with a bank for his entire project. But in most cases now, the down payment is minimum 20%.

This means that you would need to provide this amount upfront. And since home loans are for very large amounts, even 20% can be difficult to come up with.

Bottomline: Go in for a bank that asks for a lower down payment. That is, go in for a bank finances the maximum percentage of your home loan.

How to choose between a fixed and floating rate home loan?

This is one of the biggest dilemmas that people face while taking a home loan – what kind of interest rate to go for? Should you go for a fixed rate loan, or for a floating rate loan?

Fixed Interest Rate Home Loan 

In this type of home loan, the rate of interest remains fixed throughout the tenure of the loan. Irrespective of the interest rate movements in the market, the rate remains the same as that contracted during the start of the loan.

For example, if the fixed rate home loan is given at 9.5% rate of interest, the interest rate would remain at 9.5% even if the market rate goes up to 11%, or if the market rate goes down to 7.5%.

Articles that you would like to read:

• “Want to retire early? Here’s what you need“
• “What is Price to Earnings (PE) ratio?“
• “Goal Based Investing“
• “Want to own a company? Buy stock!“

Advantages 

• Fixed Outgo: Since the rate of interest is fixed, the EMI remains fixed. Therefore, you know the exact monthly outgo on the EMI, and can budget accordingly.
• Protection against adverse interest rate movement: The rate of your loan remains the same even if market rates move up. This means you are protected from higher interest rates.

Disadvantages 

• Can’t take advantage of lower interest rates: Even if the interest rates in the market go down, you would be stuck with your interest rate – you would not benefit from lower rates.
• Higher interest rate, Higher EMI: The interest rate charged for fixed rate home loans is usually 0.25% to 1.5% higher than the rate offered on floating rate home loans. Therefore, your EMIs for the same loan amount would be higher in case of fixed rate home loans.
• Money Market Clause: Many banks have a clause in their agreement, which states that in case of adverse market movements, the bank has the right to adjust your interest rate. It means that although your loan is supposed to have a fixed rate, the bank can change the rate! The clause doesn’t specify exact events for which the bank can change the rate, so it is very open ended, and blatantly favours the bank. Therefore, if you are negotiating for a fixed interest rate home loan, find out if the bank has such a clause. If yes, try your best to convince the bank to remove it!

Floating Interest Rate Home Loan 

As the name suggests, the interest rate in a floating rate home loan keeps “floating”, or keeps changing.

In theory, the rate would fluctuate with the change in the prevailing interest rates. Thus, if prevailing interest rates go down, the interest rate on your loan goes down too, and the same way, if the prevailing interest rates go up, the interest rate on your home loan goes up.

There is a fixed interval, usually six months, when the interest rate on your home loan is reset depending on the prevailing interest rates.

But there is a problem: The methodology used by the banks to judge the prevailing interest rates and to reset the interest rate on your home loan based on it is totally non-transparent. And therefore, in the past few years, it has been observed that the floating rate on the home loan goes up if the prevailing interest rates go up, but doesn’t go down if the prevailing rates go down!

What the banks do is that they tie the floating rate on your home loan to their internally defined Prime Lending Rate (PLR). They don’t disclose the methodology to calculate this, and it remains totally at their discretion. And they increase this PLR (and therefore your floating rate) when interest rates go up, but don’t decrease the PLR (and therefore your floating rate) when interest rates go down!

So, it ends up being a one sided bet, in which you are certain to lose!

Although many banks are introducing better practices, we have a long way to go.

The field of personal finance is vast, and it can take years to get acquainted with its various aspects. So, what should a young professional like you do? Take years to learn the basics of personal finance before starting to take financial decisions? Wouldn’t that be too late?

Wouldn’t it help if there is a crash-course in personal finance that would give you a head start in the field of personal finance? Of course, it would. And that’s exactly what this e-book is!

The following topics are covered in the book:

• Basics of Income Tax (IT)
• Saving Income Tax
• Life and Health Insurance
• Purchasing a House Through a Home Loan
• Importance of Saving and Investing Early
• Best Investment Strategies for the Long Term
• Best Investment Avenues

Interest rate change and effect on EMI / Tenure

When the floating rate on your home loan changes, there are two ways in which it can affect you: Either the EMI could change, or the tenure of the loan changes.

Thus, if the rate is revised upwards, either your EMI would increase, or the tenure of your loan would get increased to accommodate this change. In most cases, you won’t have a choice, and it would depend on the bank’s policy – most banks change the tenure of the loan.

Advantages 

• Lower interest rate: The interest rate on floating rate home loan is less than fixed rate home loans.

Disadvantages 

• All risk is yours: Although excellent as a concept, due to the way in which the banks calculate the floating rate, you end up taking all the risk.

Hybrid Loans – A combination of fixed and floating 

Most banks also give you an option to go in for a combination of these two – for example, if you want a home loan for Rs. 20 Lakhs, you can take the loan for Rs. 10 Lakhs on a floating rate, and for the remaining Rs. 10 Lakhs on a fixed rate. It can be in any combination, not necessarily 50-50.

This option is suitable for people who want benefits of both fixed and floating rate loans!

Automobile / Car Loans

Since there are many options available to finance your automobile purchase, lets understand them better so that you can choose what is best for you.

Margin Money Scheme / Regular Auto Loan 

This is the most basic, and the most popular option. Here, you pay your share of the cost of car – called the Margin Money – and the bank gives the rest as a loan. The margin money is usually 10 – 15% of the cost of the car. Thus, the bank finances 85 – 90% of the cost of the car.

You repay the loan in the form of Equated Monthly Installments (EMIs), which you give in the form of Post Dated Cheques (PDCs).

Tenure

The tenure of this type of auto loan is usually 1 to 7 years, although tenures more than 5 years are relatively rare.

As the tenure increases, the monthly EMI reduces for the same loan amount. Thus, a higher tenure would enable you to opt for a higher loan amount.

But please remember that since the tenure is long, you would pay many more EMIs, and therefore would end up paying a lot more in the form of interest compared to a shorter duration loan.

Rate of Interest

The rate of interest on auto loans is higher than home loans, but is normally lower than personal loans. The rate of interest for loans of longer duration is usually higher than the rate of interest on shorter duration loans. Also, interest rate on loans for used cars is higher than the rate of interest for new cars – it is higher by 2 – 4%.

The interest rate for auto loans is a fixed interest rate – the rate remains constant for the entire tenure of the loan, and does not change with a change in the prevailing interest rates.

Needless to say, the lower the rate of interest, the better it is.

Prepayment Penalty

There is a heavy prepayment penalty in case you want to pay back your car loan ahead of schedule – it ranges from 4% to 6% of the outstanding loan amount.

There can also be a limit to the amount you can prepay – for example, the bank may stipulate that you would incur a fee if you prepay more than 10% of your outstanding loan amount.

Some banks do offer zero prepayment penalty – especially during special promotions. Try to choose such a bank if possible. Otherwise, opt for a loan that has the lowest prepayment panelty.

Processing / Administrative Charges

This is a fee to cover the administrative expenses that the bank incurs to process your loan application. It can be anywhere from 0% to 2.5% of the loan amount.

This fee has an effect of decreasing your loan amount (and therefore, increasing the cost of your loan). For example, if you avail a loan of Rs. 3,00,000 with a processing fee of 2%, you would end up getting only Rs. 2,94,000.

Documentation Charges

Many banks charge documentation charge to cover their expense of documentation of your loan – for example, the amount they spend on stamp papers. This is usually a small amount (Rs. 200 to Rs. 1000), but should anyway be considered while comparing loans from various banks.

Advantages to Self Employed / Businesses

If you are self employed and buy a car on loan, you can claim the interest paid on this loan as an expense which can be deducted from your earnings. Similarly, you can claim depreciation on the car as an expense.

Variants of Margin Money Scheme 

Advance Equated Monthly Installment (Advance EMI) Scheme

Here, you get loan for 100% of the cost of the car. But the caveat is that you have to pay 4 to 8 EMIs in advance.

What does this mean? This means that you get a loan that is less than 100% of the cost of the car, but still pay a higher EMI (and higher interest) because the EMI is calculated on 100% of the amount!

Verdict: This is just a marketing gimmick, so avoid!

Security Deposit Scheme

In this scheme, you pay 10 to 30% of the loan amount to the bank as a security deposit for the loan, and the bank finances 100% of the car value. You earn an interest on this deposit, but this interest is lower than the interest on your loan. The deposit, along with the interest, is returned to you once you repay the entire loan.

Again, you get a loan that is only 70 – 90% of the cost of the car, but still pay a higher EMI (and higher interest) because the EMI is calculated on 100% of the amount!

Verdict: This is again only a marketing gimmick, so avoid!

Hire Purchase 

Apart from the margin money scheme, this is another option of financing your auto purchase.

Here, the financial institution actually buys the car on your behalf, and you “hire” the car from the institution. Under the agreement, you “purchase” the car from the financial institution at the end of the term of the agreement. It should be noted that this amount is usually very low – it can be as low as Re. 1!

The Hire Purchase option for financing a car is usually offered by Non Banking Financial Companies (NBFCs).

Advantages to Self Employed / Businesses

If you are self employed and buy a car through Hire Purchase, you can claim the interest paid on this loan as an expense which can be deducted from your earnings. Similarly, you can claim depreciation on the car as an expense.

Lease 

This is another option for financing the purchase of your car.

Here, the bank owns the car. The bank (called the Lessor) leases it to you (called the Lessee) for a fixed monthly amount. At the end of the lease, you have an option to buy the car at a predetermined price.

Leases are also usually offered by NBFCs.

Advantages to Self Employed / Businesses

If you are self employed and lease a car, you can claim the entire lease amount as an expense which can be deducted from your earnings. But since the car is owned by the bank, and not you, you can not claim depreciation on the car as an expense.

“My Financial Plan” is my online financial planning service that aims to look after your long term financial well being. It looks at your financial health in a strategic way. The idea is to plan for important life events in advance, so that you can meet their financial demands comfortably.

It provides you a well planned path that you can follow for making your investments, so that you can achieve all your financial goals easily. It includes:

• Your income and expenses
• Your investments
• Your life and health insurance needs
• Your asset allocation
• Your net worth
• Your financial goals
• and more…

(Please check out “My Financial Plan – What is included” to find out the services that you get when you avail of “My Financial Plan”.)

For more details, please visit My Financial Plan.

That brings us to the end of this e-course.

I hope you enjoyed it. Did you like the course? Was it useful? Would you like to suggest any changes? I would love to hear your feedback about this course, so that I can improve it further. Please write to me at: info@raagvamdatt.com