Photographs: Rediff Archives Harsh Roongta
While teaser rate home loans do make life easier for a borrower in the first few years, the Reserve Bank of India has expressed concern in the way banks -- both public and private -- are offering such loans to customers.
The RBI's concern stems from the fact that borrowers may not fully understand how these loan works.
'In the area of housing loans, teaser rates are increasingly being offered which is a cause for concern. I hope banks are ensuring that borrowers are well aware of the implications of such rates and the appraisal takes into account repaying capacity of the borrowers when the rates become normal', the central bank had recently made its displeasure public.
The point being made was that when the 'teaser rate' (see box below) period is over (2 to 3 years in most cases) and interest rates shift to the normal floating rates prevalent at that time the consumers may not be able to cope up with the resultant increases in EMIs, especially if, as widely expected, interest rates go up significantly in the meantime.
SBI who pioneered these loans prefers to call them 'low cost' loans rather than 'teaser rate loans.
Whatever be the label, in the Indian context, it has meant loans in which the interest rates are fixed for the first 2 to 3 years (5 years also in a couple of cases) and which reverts to regular floating rates after the initial fixed interest rate period is over.
For example for a loan of Rs 20 lakh SBI would charge a fixed interest rate of 8 per cent in the 1st year and 8.5 per cent in the next 2 years and from the 4th year onwards it will have a floating rate of 2.75 per cent below SBI Advance Rate (currently 11.75 per cent) effectively meaning if SBI Advance rate remains where it is today the rate in the 4th year will be 9 per cent (SBAR of 11.75 per cent minus 2.75 per cent = 9 per cent).
The EMI per lakh on this basis works out to Rs 836 in the first year Rs 867 in the next 2 years and Rs 895 after 3 years.
Will teaser loans shock customers in 2013?
I give a small calculation here for better understanding.
Take the case of a typical 30-year-old salaried person with a net salary of around Rs 40,000. As per the eligibility calculations followed (see box below) for disbursing teaser rate home loans he would be able to get a loan of Rs 20 lakh from State Bank of India (SBI).
If he goes for the normal option of regular floating rate loans, as they exist now, he will get the loan at an interest rate of 8.75 per cent (EMI per lakh of Rs 884) and will also be eligible for a similar loan amount of Rs 20 lakh.
Now let us run a simulation to see what happens if the interest rates rise by 2 per cent in 2010, 1 per cent in 2011 and another 1 per cent in 2012 or a total of 4 per cent in the next 3 years.
If this happens, in the case of the SBI teaser rate home loan, the interest rates from the fourth year will go up to 13 per cent.
If he had gone for the regular floating rate loan the interest rate would be 10.75 per cent (original rate of 8.75 per cent plus 2 per cent) in the first year, 11.75 per cent in the second year and 12.75 per cent for the period after that.
The loan eligibility is calculated taking into account the EMI after the teaser period is over.
As per the above example the EMI per lakh of loan in the 4th year would be Rs 895. Typically the banks assume that 40 per cent to 50 per cent of the net income is available for repayment of home loan.
Therefore from the income of Rs 40,000 about Rs 16,000 (40 per cent of Rs 40,000) to Rs 20,000 (50 per cent of Rs 40,000) is available to be paid as an EMI.
Based on an EMI repayment capacity of Rs 16,000 to Rs 20,000 and an EMI per lakh of Rs 895 we can back calculate the loan eligibility amount at Rs 18 lakh to Rs 22 lakh or say around Rs 20 lakh.
The instalment to income ratio (IIR) in both cases go up sharply from 44 per cent to 57 per cent (indicating that a larger proportion of the income will go towards servicing the home loan) at the end of 3 years and in both cases are almost at the same levels.
This means that irrespective of the type of loan the degree of difficulty in repayment would be similiar in both the loans if rates increase steeply by 4 per cent over 3 years.
Will teaser loans shock customers in 2013?
In both cases an 8 per cent annual increase in income will ensure that the IIR remains at the original levels.
But in the regular floating rate loan the consumer ends up paying for the increase in interest rates in the first 3 years also. This increase will ensure that the IIR falls back to the mid-forty levels that are considered safe by Indian standards.
So clearly whether the consumer chooses the 'teaser rate' product or the regular floating rate product he would face some difficulty if interest rates rise steeply as the IIR will increase to uncomfortable levels of 55 per cent plus. However, the IIR can fall back to reasonably comfortable levels if net income rises by 8 per cent per annum which should not be a big issue if our overall economic growth does not falter.
What could perhaps help the banks and consumers is if a transparent regime is put in place to ensure that increases in interest rates (and decreases for that matter) are worked out in a transparent and objective basis so that consumers are better prepared for such increases and the actual increase doesn't come as a shock to them.