With interest rates rising on your home loans, should you pay a higher EMI or increase the tenure of your loan?

In May 2005, Ratan Shetty, who works with an IT company, took a home loan of Rs 10.5 lakh at an interest rate of 7 per cent for a tenure of 20 years. At that time, he was paying an EMI of Rs 7,443. In just two years, the interest on his home loan has risen to 11.25 per cent, and his EMI has increased to Rs 10,453, a rise of more than Rs 3,000 per month.

When interest rates rise, home loan takers like Ratan have a few options:

Which option is the best? This depends on your age, your overall financial situation and the future course of interest rates. Let’s look at the advantages and disadvantages of each choice.

Pay a higher EMI

If you have taken a Rs 10 lakh loan for a 10-year term, half a percentage increase in interest rates will increase your EMI by around Rs 290. If you expect interest rates to rise in the future, increasing your EMI may be the best option because you have the advantage of not prolonging your loan period at higher rates. In addition, you may also be able to get tax breaks on your increased interest outgoings.

The disadvantage is the pressure that the higher EMI puts on your monthly budget. You may have to sacrifice some aspect of your lifestyle or reduce your financial investments. If you are financially over-stretched now, it may be better to keep the same EMI and lengthen the tenure.

Increasing the tenure of the loan: If interest rates fall in the future then you will benefit from this strategy; the opposite holds if interest rates rise. In a rising interest rate regime, increasing the tenure of the loan will increase the cost of your home.

One problem with extending your loan is that banks generally don’t extend tenure beyond retirement age (generally considered to be 60 for salaried individuals and 65 for self-employed). Therefore this option may not be available if you are close to retirement. Another problem is that some banks put a cap on the maximum tenure and it may not be possible to increase it beyond 20 or 25 years.

Prepayment
 
This means paying a lump sum which reduces your outstanding balance so that your EMI doesn’t rise even after taking into account the higher interest rates.

For example, assuming you have a Rs 15-lakh loan for a 20-year term at an interest rate of 12%, your indicative EMI would be around Rs 16,517. If the interest rate inches up to 13%, you would have to pre-pay around Rs 90,000 to retain the same EMI and tenure.

Raising that kind of cash may be difficult since you have already stretched yourself to buy that dream home. In that case, you may have to liquidate some of your investments or pledge financial assets such as an insurance policy or national savings certificate and receive an overdraft facility that will allow you to make the pre-payment.
If you choose to pre-pay, check if there is any penalty for the partial pre-payment of your loan. Take into account the loss of tax benefits because your tax-deductible interest payments are lower after pre-payment.

Options

* Pay higher monthly installments (EMI or equated monthly installments) as he has done over the last two years.
* Increase the tenure of the loan, or pre-pay part of the loan to retain the original EMI and tenure.

The author is CEO of apnaloan.com and can be contacted at ceo@apnaloan.com