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Understanding Home Loan

You must have heard the famous words “Home is a shelter from storms – all sorts of storms” .Buying your own home should be a priority even if it means availing a home loan. So understanding home loan is very important.

What are home loans?

You can avail a home loan from a bank or a housing finance Company to buy, construct or repair/renovate your house.

How do banks calculate the interest on your home loan?

Banks fix the interest on your home loan based on their base rate. Base rate is the minimum lending rate of the bank. Banks do not lend below the base rate. Each bank fixes its own base rate. Banks are free to decide the base rate based on their cost of funds. (The interest banks pay on the savings/current/fixed deposits invested with them). Banks have administrative and other expenses .They also need to earn a profit on the home loan they give you. Spread takes into account the expenses and profits of the bank when it has to lend you a home loan.

Your home loan lending rate is calculated based on :

What is a floating rate home loan?

The home loan you avail is generally a floating rate home loan. The interest rate of the floating rate home loan rises and falls with the market rate. (repo rate) The interest rate charged for a floating rate home loan is linked to market rates (repo rate).When the repo rate reduces the bank base rate is lowered.

Why does the interest on your floating rate home loan reduce?

If the bank has a base rate of 10.25% and fixes a spread of 0.5%, the bank is charging you an interest on your floating rate home loan of 10.75%. If the market rate falls (repo rate is cut) the bank may reduce the base rate by 0.25%.The new base rate is 10.0%. The bank does not reduce the spread (margin it gets on your home loan).It continues to charge a spread of 0.5%. When the repo rate reduces, the bank base rate is lowered. But banks do not cut your home loan EMI’s? They reduce the tenure (repayment time period) of your home loan. The main reason for this is the convenience of the banks. Banks prefer reducing the repayment tenure of your home loan rather than the hassle of recalculating/readjusting your home loan EMI’s.

How do you gain if the bank reduces the repayment tenure of your floating rate home loan?

Your floating rate home loan EMI’s are divided into 2 parts:
EMI (Principal) + EMI (Interest). Most of your repayments in the initial years you avail the home loan goes towards the interest repayments and only a small fraction goes towards the repayments of the principal. Most of the principal repayments are made towards the last few years of the home loan. (End of the home loan tenure). When the bank cuts its base rate the tenure of your home loan reduces. This reduces the interest you have to repay on your floating rate home loan and most of the amount you repay goes towards paying back the principal on your floating rate home loan. This means your floating rate home loan is repaid at a faster rate. You avail a floating rate home loan from a bank and are paying an interest of 10.25% for a tenure of 10 years. If the bank cuts the base rate by 0.25% the repayment tenure reduces by 8-12 months. You avail a floating rate home loan from a bank and are paying an interest of 10.25% for a tenure of 20 years. If the bank cuts the base rate by 0.25% the repayment tenure reduces by 2-3 years. Longer is the tenure of your home loan greater are the benefits of a base rate cut by the bank.

Why do banks charge a higher interest on the floating rate home loans to existing customers compared to a new customer?

You have availed a floating rate home loan 2 years ago of INR 40 Lakhs from a bank. The bank charges you an interest of 10.5% on a floating rate home loan of tenure 20 years. Your friend has just availed a floating rate home loan of INR 40 Lakhs from the same bank with the same tenure of 20 years. He is charged an interest of 10.25% on the floating rate home loan.

So why does this happen.....

The bank has a base rate of 10 % and charges you a spread of 0.5%.

Your home loan floating rate is 10.5% :

The base rate of 10% remains the same for you and your friend. The bank charges a spread of only 0.25% for your friend in order to entice him to avail a home loan with them. He pays an interest of only 10.25% on the home loan.

Your friend’s home loan floating rate is 10.25% :

What if the bank cuts the base rate 6 months later?

If the market rate reduces (there is a cut in the repo rate), the bank reduces the base rate. The base rate is now 9.75%.The spread remains the same.

Your new floating rate home loan is 10.25% :

Your friend’s new floating rate home loan is 10% :

You have a famous saying by Albert Einstein “Any fool can know. The point is to understand. This also applies to your home loan.So understand home loan before investing.

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