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Change in interest rate: Impact on floating rate home loan, EMI and tenure

The interest rates have been very volatile in the last few years. A couple of years back, the rates were going down. And they have been moving up for some years now.

What effect does a rate change have on a floating rate home loan (or mortgage)? Does it change the amount of the EMI? Does it alter the tenure of the repayment period? Let’s explore.

With inflation rising to over 12%, the interest rates on deposits and loans have also been steadily climbing. The rates were increased in July, and were increased again in August.

This has meant that the interest rates for floating rate home loans have also increased significantly over the past few months.

Since many of us have taken home mortgage loans with a floating rate, let’s analyze how this increase effects the equated monthly installment (EMI) and the repayment period / schedule.

(To know about the basics of home loan, please read “An introduction to home loans and factors to consider“)

The first step is to understand the composition of the Equated Monthly Installment (EMI) that we pay every month.

 

Understanding the composition of Equated Monthly Installment (EMI)

Each EMI that we pay consists of two components: Interest on the outstanding amount of the loan taken, and repayment of principal.

Login Required To find out the EMI for your home loan at various rates of interest, and to find the exact breakup of your EMIs over the years, please download the free “Home Loan Amortization / Repayment Schedule”

With each EMI payment, we pay back some of the loan in the form of repayment of principal. As a result, with each EMI payment, the interest component in the subsequent EMI goes down a little, and the principal repayment component increases a little.

At the beginning of the repayment schedule (that is, during the initial years of the home loan repayment), the interest component is much higher than the principal repayment component in an EMI.

Over years, as we repay some principal with each EMI, the interest component decreases, and the principal repayment component increases.

Towards the end of the home loan repayment schedule (that is, during the last few years of the home loan repayment), the principal repayment component is far higher than the interest component in the EMI.

Login Required To find out the EMI for your home loan at various rates of interest, and to find the exact breakup of your EMIs over the years, please download the free “Home Loan Amortization / Repayment Schedule”

 

What happens when interest rate increases?

Simply speaking, when interest rate increases, you need to pay a higher amount as interest for the amount that you borrow.

This means one of the two things:

  • Your EMI amount increases to accommodate the increased interest payment, so that the tenure of your housing loan stays the same, or
  • The EMI remains the same and the tenure of the home loan increases, so that you can pay the increased interest through more EMI payments.

EMI increases, Tenure remains the same

This is quite intuitive – since you have to pay more interest, you pay more every month. This means that your EMI amount increases, but the overall period or duration of the loan repayment remains the same.

Let’s take an example. Say you take a Rs. 20 Lakh loan for 20 years at an interest rate of 10.5% per year. Your EMI would be Rs. 19,968 per month.

Now, if this rate increases to 11% per annum, the EMI would be Rs. 20,644 per month.

Login Required To find out the EMI for your home loan at various rates of interest, and to find the exact breakup of your EMIs over the years, please download the free “Home Loan Amortization / Repayment Schedule”

Tenure increases, EMI remains the same

In this case, the EMI remains the same. But since you have to pay more interest now, the number of EMIs to be paid increases. That is, the years for which you have to repay the loan increases.

Continuing the same example of a Rs. 20 Lakh, 20 year loan, an increase of 0.5% increases the tenure of the loan by upto 24 months. Thus, you would end up paying the EMIs for 22 years instead of 20 years.

Remember – Since the tenure of the home loan increases, you are repaying the loan over a longer term. Therefore, the proportion of the interest component in the EMI increases significantly in the initial years.

 

What is better – EMI increase or Tenure increase?

Both have their pros and cons.

EMI increases, Tenure remains the same

The biggest disadvantage is that not everyone can afford an increased EMI.

Most of us stretch ourselves when we buy a home – we try to buy the best possible home as it is a once-in-a-lifetime purchase for most of us. This means that we end up taking a loan that has an EMI that we can just about afford. Any increase in the EMI might not be sustainable by our monthly budgets!

And even if you are willing to pay a higher EMI, the bank may refuse to do so in cases where the increased EMI amount becomes more than a certain percentage of your total monthly income.

But the advantage is that you have to pay for lesser number of years.

Tenure increases, EMI remains the same

The disadvantage here is that you have to keep repaying the home loan for a longer period.

But the advantage is that these extra EMI payments towards the end of the loan would not pinch at all. This is a positive side-effect of inflation – it reduces the value of the Rupee each year, and by the time you reach the fag end of your repayment schedule, the EMI would form a negligible fraction of your monthly income.

(To read a detailed analysis of this positive effect of inflation, please go to “Settle early in life – buy a home when young”)

For example, let’s take the EMI of Rs. 20,644 that we have in our example. In the 21st year, it would be equivalent to today’s Rs. 1,911 if the rate of inflation is 12%, and would be equivalent to today’s Rs. 6,073 if the rate of inflation is 6%.

You might read large headlines in newspapers like “Home loan takers to pay Rs. 5 Lakhs more as interest” when interest rates increase, but remember, you would be paying this extra amount years down the line, when the value of any extra money paid would be a actually very small in real terms due to the effect of inflation.

 

What should you choose?

Most banks have their own rule about choosing one of these. In that case, you would have to go by the bank’s policy.

But there are some banks (like State bank of India – SBI) that give the choice to the customer.

In such a case, choose to keep the EMIs constant and extend the tenure. As explained earlier, although you would pay more as interest over the tenure of the loan, you would end up saving in real terms.

The only problem would be for people nearing retirement – if you are nearing retirement, the bank would not allow you to increase the duration of your repayment period.

For everyone else, keeping the EMIs constant and extending the tenure should be the best option.

Do you have a floating rate home loan? What have you done? Have you increased your EMI, or extended the tenure? Please let me know through comments below.

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