Understand Your Home Loan
Oct 02, 2012

Author: PersonalFN Content & Research Team

We are currently in a falling interest rate scenario. One of the key benefits of this, apart from the benefit to debt mutual funds, is that home loan rates (among other loans) are falling.

Recently, SBI announced a cut in its home loan rate to 10-10.15% p.a. being the biggest lender in the country, other banks and lending institutions tend to follow in SBI's direction, even if they don't cut their rates to SBI's rate level, they will stay within a close range.

If you have an existing home loan, for which the rate is higher than what is available to new home loan takers today, you may be considering switching your home loan.

But before you make your mind up, you need to fully understand your home loan and your EMI. Let's see what you need to know.

When considering switching, there are 3 main things you need to know:

How long you have left on your current home loan,
What interest rate your new lender will offer you,
What the savings will be.

While all switches to cheaper lenders could be beneficial, not every switch is equally beneficial.

The reason it might not be very beneficial to switch your lender is:
if you have had your existing home loan for very long and most of the tenure is over, then your EMIs comprise primarily principal, with very little interest component.

How is an EMI structured?

Here is how a typical EMI is structured in the first 5 years of a hypothetical 20 year, Rs. 50 lakh loan at 10.50% p.a.:

Date	1-Jan-12
Loan Amount	5,000,000
Term	20
Rate	10.50%
EMI	49,919

EMI No.	Date	Opening Balance	EMI	Interest	Principal	Closing Balance
1	1-Jan-12	5,000,000	49,919	43,750	6,169	4,993,831
2	1-Feb-12	4,993,831	49,919	43,696	6,223	4,987,608
3	1-Mar-12	4,987,608	49,919	43,642	6,277	4,981,331
4	1-Apr-12	4,981,331	49,919	43,587	6,332	4,974,998
5	1-May-12	4,974,998	49,919	43,531	6,388	4,968,610
6	1-Jun-12	4,968,610	49,919	43,475	6,444	4,962,167
7	1-Jul-12	4,962,167	49,919	43,419	6,500	4,955,667
8	1-Aug-12	4,955,667	49,919	43,362	6,557	4,949,110
9	1-Sep-12	4,949,110	49,919	43,305	6,614	4,942,496
10	1-Oct-12	4,942,496	49,919	43,247	6,672	4,935,823
11	1-Nov-12	4,935,823	49,919	43,188	6,731	4,929,093
12	1-Dec-12	4,929,093	49,919	43,130	6,789	4,922,303

If you look at the table above you will see that for a home loan taken in January, 2012, for Rs. 50 lakhs, at 10.50% interest per annum with a 20 year tenure, the EMI will be approximately Rs. 49,919 per month.

Let's look at the first 12 months of the loan.
Your first month EMI of Rs. 49,919 is broken up as follows: Rs. 43,750 interest repayment and only Rs. 6,169 principal repayment.

It is very heavily weighted in favour of interest paid, and very low in terms of principal repaid.

Why is this?

The more principal you repay, the lower your debt is, the lower interest you will have to pay going forward. This is why loans are typically structured as very interest heavy in the beginning years, and very principal heavy only towards the end of the tenure. The bank wants to ensure you pay as much interest as possible. This will be the case with all loans, not just home loans.

Now let's look at the last year of the same loan i.e. the 229th month till the 240th month of the loan.

EMI No.	Date	Opening Balance	EMI	Interest	Principal	Closing Balance
229	1-Jan-31	566,305	49,919	4,955	44,964	521,341
230	1-Feb-31	521,341	49,919	4,562	45,357	475,984
231	1-Mar-31	475,984	49,919	4,165	45,754	430,230
232	1-Apr-31	430,230	49,919	3,765	46,154	384,075
233	1-May-31	384,075	49,919	3,361	46,558	337,517
234	1-Jun-31	337,517	49,919	2,953	46,966	290,551
235	1-Jul-31	290,551	49,919	2,542	47,377	243,175
236	1-Aug-31	243,175	49,919	2,128	47,791	195,383
237	1-Sep-31	195,383	49,919	1,710	48,209	147,174
238	1-Oct-31	147,174	49,919	1,288	48,631	98,543
239	1-Nov-31	98,543	49,919	862	49,057	49,486
240	1-Dec-31	49,486	49,919	433	49,486	0

You will notice how heavily weighted it is in terms of principal being repaid and how low the interest repayment proportion is. This is because all the interest to be repaid has been claimed in the earlier years, by the breakup structure of your EMI.

Why do banks do this?

A home loan is a big liability, which means it is often a big risk to the bank. They will protect themselves as much as they can to avoid having bad debts and repossessions on their books. Also, they are aware that not all home loan takers stay with their original lenders for the entire tenure. They want to ensure that if you switch, they have gotten as much of their loan's interest as possible.

What does this mean for you? This means that beyond a certain point in time, it becomes much less useful for you to switch your home loan to one that is charging you a lower rate. If you were to switch in the initial years of your loan, it would be much more beneficial for you, because you still have a lot of interest-heavy EMIs ahead of you. and if you switch to a lower rate home loan, your interest paid will be less. You could save lakhs of rupees in interest by making the switch.

But if you switch much later, then you are mainly paying back principal and very little interest. You then need to decide whether the hassle of the paperwork is worth it to you, if you have, say, only a few years left on your loan.

How do I know whether it is beneficial enough for me to make a switch and go for a cheaper lender?

Your financial planner will run the numbers for your specific situation and show you exactly how much the benefit is to you, if you switch to a cheaper lender, keeping all other factors in mind. Also, know your own credit score, and you can use it as a bargaining tool when taking a home loan.

This will be considered as part of your overall financial plan which will also include planning for life goals such as your retirement, your children’s educations and so on.

Remember, your home loan is the biggest liability for an asset you will ever have in your life. If you can benefit by switching to a less expensive lender, you should certainly do so, under your planner's guidance.