The EMI Conundrum

Wed, May 19 09:24 AM
Rajeev Sharma couldn't believe the bank statement. He decided to talk to old buddy Atul Balaram Kaslekar, or 'Abacus', who somehow seemed to know these things.

"Oye, Abacus. I can't figure this out. I've been paying my 30 lakh home loan for four years and the latest statement tells me I still owe them 28.6 lakhs. I'm paying them Rs 32,500 a month! How, Abacus, how?"

Abacus paused. He keyed the figures into a spreadsheet.

"Sharma, start from the beginning. Jan 2006, you signed the deal. The bank paid in installments for 18 months while your house was built. For this time, the bank asked you only for a 'pre-EMI' which was just the interest - a low 7.5% in those great times. In 18 months you had paid 1.97 lakhs as interest."

"Holy Moly!" said Sharma. "That much! Though it seemed nice to not pay the full 25,000 EMI for a while. But let's leave that alone."

"Ok. Here's how the monthly payment system, of Equated Monthly Installments, or EMIs, works. You got a 30 lakh loan for 20 years at 7.5%. For the first month - October 2007, your outstanding principal is 30 lakhs. You pay Rs 18,750 as interest alone. Anything above that brings your principal down. The next month you pay interest on the new lower principal, and the sum above that goes again to cut down the principal. And so on, till 20 years are done. The calculation - a formula that calculates the fixed payment so that the outstanding is zero after 20 years - gives us a figure of Rs 24,167 per month. And you paid a little more because they charged 10% service tax on the interest."

"I see."

"In the early years, the interest component of the EMI is large. Over time as you repay principal it becomes smaller and smaller, and the principal part becomes bigger and bigger. At the end of year 1, about 2.4 lakhs of the 3 lakhs you paid was just interest and taxes. You still owed the bank 29.4 lakhs," said Abacus. "At that point, they increased the interest rate on your loan to 8.5%."

"Wow, just 60,000 off my principal? That's rough. Yes, they told me that even though rates went up, nothing will change, I continue to make the same monthly payment."

"Well, If they recalculated the EMI on the new interest rate, they would have to bump your payments up to nearly Rs 28,000 a month. They decided instead to let you keep the same monthly payment, and the tenure of the loan scaled up to 23 years instead."

"Oh, ok. It sounded far away at the time, I suppose," said Sharma, wondering why he hadn't talked to Abacus then. He could have afforded the 28K in 2008, but nobody gave him the option.

"But Sharma, higher interest, same payment? Very little was left each month to pay back principal. Six months later they were going to increase the interest to 9.5%. Your outstanding was still 29.12 lakhs. If they stretched your loan tenure again, you would take 31 years to pay off the loan. That's past your retirement age. So they reworked the loan to pay 30K a month over 20 years instead."

Sharma digested all the information. He had paid Rs 25,000 a month for 18 months, and he'd paid back only 90,000 of the loan. He growled.

"That was really shocking. They were offering new customers loans at 8.5%, but I had to pay 9.5%. If I moved to a different bank, I would pay 2% as pre-closure charges, and with other charges, and I would be poorer by 75,000 rupees for a measly 1% cut in my rate."

"Tough," said Abacus. "Anyhow, later the bank bumped up interest to 11%, and payments went up to 32.5K a month. At the end of April 2010, as a result of all of this, you have Rs 28.6 lakhs outstanding, and 19.5 years to go. Of nearly 11 lakhs paid over the last four years, only 1.4 lakhs have been used to pay out principal; the rest has gone to various pockets that aren't yours."

Sharma was incensed. How should you deal with things like this?

"First, in the pre-EMI period, you could afford to have paid the full 25,000 per month. If the rest of the deal went exactly as it did, you would currently owe only 25.9 lakhs."

Abacus continued, "Second, you told me last year you had three lakhs in a long term fixed deposit? Well, that FD was at a measly 8%, while you paid 11% on your housing loan. That money could have part paid your home loan and save you 2 lakhs in interest over the next four years. The bank effectively lent you your own money at the 3% extra interest."

"Stop, Abacus, and meet my ego. He's slightly deflated today."

"Don't let it get to you. That other bank loan you ditched because it cost you 75,000 for a measly 1% lower interest? You would have made that money back in four years, and in the remaining term of the loan, paid substantially lower interest. The savings seem miserly, but over 20 years, 1% is a huge amount."

"Hmm. This seems like it costs a lot, but shouldn't I count the tax benefits?"

"What tax benefits? Your principal, up to 1 lakh a year, is tax-free under section 80C; but then your daughter's school fees and the provident fund paid from salary qualify under the same 1 lakh limit, so you don't get anything extra on your home loan. The interest paid on your home loan is tax free upto 1.5 lakhs a year - you pay substantially more than that - but you either pay the bank or the government, and the government takes only 30%, so what tax did you really save?"

"Well, compared to renting..."

"The house you stay in rents at Rs 12,000 a month, less than the interest per month for a long time. And you get a tax benefit for renting too."

Sharma said, "Understood. Ok, the past is past. I can feel bad, but it is a sunk cost. What you're saying is - as you save money, make part-payments up your home loan. And shift to a different bank if the cost and benefits work out. But what else should I look for?"

"Take a low fixed rate loan if available," said Abacus. "Watch out for 'pseudo fixed' rates - some banks will tell you they change the fixed rates also every few years. Get a loan without a pre-payment penalty - most public sector banks don't charge that.

Don't buy insurance from the bank. Banks may demand it to cover in case of an untimely death, but they offer insurance that's way too expensive; other market options are better.

"Any defaults on other payments or credit cards will affect future ability to refinance loans at lower rates. Pay off the most expensive loans first.

"Finally, don't be afraid to challenge the bank. You can complain, even online, to the banking ombudsman, and the process works."

Sharma was impressed. "Thanks Abacus! I wish I'd come to you earlier."

"Sharma, how do you think I know? I just refinanced my loan. One month ago, I was in the same position. Now, to fix our respective egos, let's go get that drink you promised."

Deepak Shenoy trades the Indian markets and writes at Capital Mind. He's also working on an upcoming stock market site. You can reach him at deepakshenoy@gmail.com or @deepakshenoy.