This article helps you choose a home loan that is suitable for your personal situation.
First time home buyers: should you choose fixed, floating or overdraft type home loan?
25 May 2022 - Contact Sayan Sircar
14 mins read
This article helps you choose a home loan that is suitable for your personal situation.
Table of Contents
- How does a home loan work?
- What are the types of loans that are there?
- How much extra interest do you pay with an OD loan vs a term loan?
- Which loans should you choose and why?
How does a home loan work?
A term loan is a standard loan type where a fixed amount is taken as a loan, called the principal, and then paid back in instalments, called EMI, every month. The EMI is designed to be fixed over the term of the loan. If the interest rate of the loan changes over time, the EMI will change. This point is the distinction between fixed and floating types of term loans.
The bank gives a home loan to own the property while using it until you pay back the loan via EMIs. An Equated Monthly Instalment plan (EMI) is a standard way to pay off a loan by making a fixed payment monthly that has both interest and principal in the same amount.
EMI = Principal + Interest
In each EMI, the split of the interest and principal changes since the interest is based on the outstanding loan balance at that point, and the rest of the EMI is the principal. As the chart shows, the interest part drops off with time, and the rest is the principal. The actual numbers in the chart relate to a ₹50 lakhs home loan taken at 8% for 25 years. The EMI is ₹38,591. The down payment amount is ₹12.5 lakhs.
You can test the numbers using this calculator:
This article is the next part of our guide to purchasing your dream home. Read the other parts here:
- How to calculate the SIP amount for the down-payment of your dream home?
- Should you sell your mutual funds to buy a house?
- Goal-based investing: check if you can purchase your dream home
- How does your risk profile change with a home loan?
- Where to save for the down-payment of a home?
- Should you stretch to buy your dream home?
- What is the best home loan tenure?
- Should you use your stock market profits to prepay a home loan?
- First time home buyers: should you choose fixed, floating or overdraft type home loan? « this article
What are the types of loans that are there?
Floating rate loans
Floating rate loans are the most common type of loans offered for home loans.
Floating rate = Base rate like Repo or MCLR + Spread
The interest rate on your home loan will typically be a floating rate that will fluctuate with overall interest rates in the economy. Usually, movements of the RBI repo rate indicate the direction of interest rates in the economy, while home loans are tied to the Repo Linked Loan Rate (RLLR) or Marginal Cost of Funds-based Lending Rate (MCLR) as per RBI.
As interest rates fluctuate, so will your EMI over time. As the economy matures, interest rates are expected to decrease, taking down the amount you pay per month on your home loan. Similarly, while inflation is also likely to reduce with time, the purchasing power of the money paid as EMI will decrease as well over time.
Term loan Terminologies
- Drawing Power (DP): This is the outstanding balance of the loan or simply the principal to be paid back
- EMI: The EMI of the loan that consists of Principal and Interest. The EMI will remain constant throughout the loan tenure, assuming the interest rate does not change
- Interest part of EMI: The interest component of the EMI. The calculation is against drawing power on a daily basis
- Beginning and Ending Balance: This number (they are the same), is essentially the amount you owe to the bank. As you pay, the principal reduces. The ending balance of the current period becomes the beginning balance of the next one. Ending balance = Beginning Balance - Principal Component of the EMI in this month
Fixed rate loans
Fixed rate loans are a slight misnomer though on paper they offer loans with rates that do not change with the movement of interest rates in the economy. These loans seem to be a good solution to the problem of interest rate rises that increase your EMI. If the rates never rise (or fall), then you no longer have to worry about this problem. The EMI will always be the same. Except when they are not:
- fixed rate loans generally have a clause for a reset in two years to bring them closer to market rates
- at the start fixed rate loans are much more expensive than floating rate
If you are thinking to take a fixed rate loan, you will be better off with a floating rate loan and keep the difference in a EMI buffer fund.
This type of loan is a special case of the floating rate loan. Any surplus money kept in the OD account saves interst since the principal is reduced by the value of this surplus when interest calculation is done. We have covered this concept in detail in this article and you should review it before proceeding further: How does an overdraft loan like SBI Maxgain work?.
In the previous article on the mechanics of the OD home loan, we had discussed three ways of using the OD account to park excess cash and the rationale of doing the same:
- Sinking fund
- Short-term goals
- Parking surplus cash
We will now show the calculations to decide if these methods will work for you.
How much extra should you keep
Please note that the OD account does not generate returns directly; instead, the returns come from interest saved on the loan. Whether that interest saving is material will depend on the quantum of money that passes through the OD account as surplus cash.
Average extra account balance to be added every month to the OD account, as a percentage of OD loan EMI, to come to the same result as the non-OD term loan (7.4% rate for OD, 7% for normal):
- Loan duration: 5 years, extra 10.42%
- Loan duration: 6 years, extra 8.68%
- Loan duration: 7 years, extra 7.38%
- Loan duration: 8 years, extra 6.40%
- Loan duration: 9 years, extra 5.64%
- Loan duration: 10 years, extra 5.10%
- Loan duration: 11 years, extra 4.56%
- Loan duration: 12 years, extra 4.12%
- Loan duration: 13 years, extra 3.80%
- Loan duration: 14 years, extra 3.47%
- Loan duration: 15 years, extra 3.26% (or ₹3126/month for ₹1 lakh/month EMI)
- Loan duration: 16 years, extra 2.93%
- Loan duration: 17 years, extra 2.82%
- Loan duration: 18 years, extra 2.60%
- Loan duration: 19 years, extra 2.50%
- Loan duration: 20 years, extra 2.28%
This list shows that unless you can park an extra surplus of ₹3,260/month or around ₹39,000/year continuously when the EMI is ₹1 lakh for a 15-year loan, then you should not go for an OD loan.
How much extra interest do you pay with an OD loan vs a term loan?
Using the same rates of 7.4% for OD and 7% for a term loan, we can calculate the extra interest to be paid as a % of principal vs term loan:
- Loan duration: 5 years, extra 1.12% interest
- Loan duration: 6 years, extra 1.38% interest
- Loan duration: 7 years, extra 1.64% interest
- Loan duration: 8 years, extra 1.91% interest
- Loan duration: 9 years, extra 2.19% interest
- Loan duration: 10 years, extra 2.48% interest
- Loan duration: 11 years, extra 2.78% interest
- Loan duration: 12 years, extra 3.08% interest
- Loan duration: 13 years, extra 3.40% interest
- Loan duration: 14 years, extra 3.72% interest
- Loan duration: 15 years, extra 4.05% interest or an extra 4.05 lakhs as interest on one crore of principal borrowed
- Loan duration: 16 years, extra 4.38% interest
- Loan duration: 17 years, extra 4.73% interest
- Loan duration: 18 years, extra 5.08% interest
- Loan duration: 19 years, extra 5.44% interest
- Loan duration: 20 years, extra 5.80% interest
This list shows that for a 15-year loan, an extra 4.05% of the principal, e.g. 4.05 lakhs/crore borrowed, is to be paid in case of an OD loan vs a standard term loan. This table shows that if you are planning to pay off the loan in a short period, the extra interest on OD account is less making the OD loan more attractive.
Combining an OD loan with an EMI buffer fund vs term loan with a prepayment
We always advocate having 6-12 months of EMI be included in the emergency fund when a home loan is taken. Additionally, if a buffer fund can be created to manage expenses in case interest rates go up. This entire fund can be parked in the OD account. Since parking this buffer fund in the OD account reduces the loan tenure, we will contrast this case with a term loan where a slight prepayment is done so that both loans can end simultaneously.
In each of the cases below, we will do this:
- OD loan: for the first 12 months of the loan payment period, accumulate 3-12x EMI in the OD account as a surplus and then pay off that as a lump sum prepayment once the ending balance of the loan becomes zero
- term loan: prepay some percentage of the EMI extra per month so that the term loan ends at the same time as the OD loan. This value is shown in the body of the table below
|Year||3x EMI||6x EMI||9x EMI||12x EMI|
Taking the 15-year loan as the example, we see from the table that:
- 3x EMI: every month for 12 months, 25% of the OD EMI is added to the OD account. In 12 months, 3x EMI is accumulated. In the case of the normal loan, an additional 2.65% of the EMI is to be prepaid monthly to end the loan at the same time as the OD loan
- 6x EMI: every month for 12 months, 50% of the OD EMI is added to the OD account. In 12 months, 6x EMI is accumulated. In the case of the normal loan, an additional 5.57% of the EMI is to be prepaid monthly to end the loan at the same time as the OD loan
- 9x EMI: every month for 12 months, 75% of the OD EMI is added to the OD account. In 12 months, 9x EMI is accumulated. In the case of the normal loan, an additional 8.82% of the EMI is to be prepaid monthly to end the loan at the same time as the OD loan
- 12x EMI: every month for 12 months, 100% of the OD EMI is added to the OD account. In 12 months, 12x EMI is accumulated. In the case of the normal loan, an additional 11.98% of the EMI is to be prepaid monthly to end the loan at the same time as the OD loan
While having a large enough emergency fund to cover the EMI for a few months is always recommended, some families with sufficient liquid assets may choose the normal loan plus prepayment route instead of the OD loan.
Which loans should you choose and why?
Fixed rate loan
The only reason a borrower may choose a fixed rate home loan if both of the following conditions are true:
- the fixed loan rate is very close to floating rate loans for their loan amount
- the loan will be paid back in 2-3 years before a reset is expected to occur
All other investors should avoid a fixed rate loan.
Overdraft loans may be chosen if at least 1-2 of the following conditions are true:
- the interest rates are very similar. Banks are competing against each other to offer lower rates to increase their lending book and overall business
- use the OD account for day-to-day expenses, savings for short term goals, keeping your sinking fund as well as the EMI buffer fund. You estimate that the average overall balance of the OD account will be higher than the minimum thresholds as calculated above
- you are not using a construction linked plan that prevents you from removing money from the OD account if needed. This issue makes the interest saving of the OD account less potent
- you are planning to pay off the loan in a short period instead of keeping it for a long time. The shorter the loan-repayment period, the extra interest on OD account is less
Floating rate loan
Every borrower who does not fall under the loan categories above should take a normal floating rate loan. The only thing to keep in mind is to take a repo linked (RLLR) based loan, instead of an MCLR based one, since the RLLR based loans react faster to rate reductions than MCLR.If you liked this article, consider subscribing to new posts by email by filling the form below.
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