Term Clusters for Home loans

Effective interest, Reducing factor, Annual, daily, Monthly reducing and EMI

The market is flooded with housing loan options. Banks and institutions are competing with each other devising new products to be one up on each other. It is ultimately the game of interests, upfront costs and EMI's which decide the overall cost of your loan.

You may often get confused that 2 lenders offer you a loan at the same rate, however their EMI's differ, this is due to the reducing factor adopted by the lenders. The EMIs may be computed using annual rests, monthly rests or daily rests.

Below is an attempt to de-mystify the whole process by way of simple illustrations.

Effective interest rates

Effective interest rates are the simple interest rates, which get compounded on the frequency of, receipt of interest that may be either, monthly, quarterly, half yearly or annually. Generally banks compound interest quarterly. In other words, Effective interest is compounded interest rates based on the actual inflows and outflows of cash.

EMI
Home loans are generally paid in Equated monthly installments (EMI). This basically means the amount you have to shell out every month towards repayment of your principal loan amount and interest. Lenders adopt different methods like annual rests, monthly rests and daily rests for reducing your loan over the loan tenure.

In Annual reducing method, though the EMI is paid monthly, however the adjustment towards interest and principal is made at the end of the year, which means that though your principal loan amount is reduced every month, the interest is calculated on the original loan amount for the full twelve months and at the end of the year the repayments towards the principal loan are adjusted.

For example: For a loan of Rs 1,00,000 at 12% interest for 1 year on Annual reducing method, the interest is calculated throughout the year on
Rs 1,00,000 though the principal loan amount is reduced every month.

Installment Amount op.Loan   Interest Principal Loan o/s 1 9333 100000 1125 8208 91792 2 9333 91792 1125 8208 83584 3 9333 83584 1125 8208 75376 4 9333 75376 1125 8208 67168 5 9333 67168 1125 8208 58960 6 9333 58960 1125 8208 50752 7 9333 50752 1125 8208 42544 8 9333 42544 1125 8208 34336 9 9333 34336 1125 8208 26128 10 9333 26128 1125 8208 17920 11 9333 17920 1125 8208 9712 12 9333 9712 379 9333 0

 

Monthly reducing method The principal is reduced at the end of every month and the interest is calculated on the reduced principal lowered every month. For the same loan amount of Rs 1,00,000 at 12% on monthly reducing the interest is calculated on the loan outstanding at the end of every month.

Installment Amount op.Loan Interest Principal Loan o/s Month 1 8884 100000 1000 7884 92116 Month 2 8884 92116 921 7963 84153 Month 3 8884 84153 842 8042 76111 Month 4 8884 76111 761 8123 67988 Month 5 8884 67988 680 8204 59784 Month 6 8884 59784 598 8286 51498 Month 7 8884 51498 515 8369 43128 Month 8 8884 43128 431 8453 34676 Month 9 8884 34676 347 8537 26139 Month 10 8884 26139 261 8623 17516 Month 11 8884 17516 175 8709 8807 Month 12 8884 8807 88 8807 0

Daily reducing Method

The principal is reduced every day as if you were repaying the loan daily and the new repayment requirements are calculated after reducing your principal and given effect on the same day. So the daily reducing balance effectively translates into a monthly reducing balance except when you make a repayment.

Now lets sum up the same example to explain the difference in the EMIs for the same interest rates but with different reducing factors, viz. Annual rests and Monthly rests.

Demonstration:

For a loan requirement of Rs 1 lakh for a period of 1 year at the same interest rate of 12%, an Housing Finance Company (HFC1) computes EMI on Annual rests and HFC2 on Monthly rests. The difference in the EMI's is shown below.

Assumptions

Loan required Rs 1,00,000 Loan Tenure 1 years Interest rate offered by HFC1 and HFC2 12% Reducing factor for HFC1 Annual Rests Reducing factor for HFC 2 Monthly Rests

Result

EMIs calculated on monthly rests are cheaper as the principal is reduced at the end of every month and the interest is calculated on the reduced principal lowered every month.

HFC Reducing factor Effective Interest EMI p.m Total payment Difference HFC1 Annual rests 12% 9333 1,11,996 5388 HFC 2 Monthly rests 12% 8884 1,06,608

If you want view results using other options, log on to our EMI calculator. You can also view the break-up of your loan and the EMI for the loan tenure.

Effective Cost - Effective interest and charges payable upfront. Processing charges and Administration costs

The second aspect which affects the cost of borrowing a loan are upfront non-refundable costs like processing charges, administration charges, commitment fees and pre-payment charges.

Processing charges are to be generally paid at the time of submitting the documents to the lender for appraisal i.e. they recover the expenses for evaluating the borrowers assets and repayment capacity.

Administration or documentation charges are paid at the time of sanction, these overheads take care of all the post-sanction documentation charges. Some lenders also charge a Commitment fee if the borrower fails to take the entire sanctioned loan amount within a specified period, this is generally charged as a % of the unutilised loan amount, for e.g. if Sarita was sanctioned a loan of Rs 2,00,000 which she has to withdraw within one month, if she utilises only 1,00,000, then 1% will be charged on Rs 1,00,0000 which is not utilised by the borrower.

Pre-payment costs is a penalty charge for foreclosing (early repayment) of a loan. Pre-payment could be either part pre-payment or full pre-payment. These costs vary between 1-2% of the loan prepaid.

These costs can actually increase your debt burden. The borrower should look at the Total cost to him in terms of interest and charges rather than EMIs only.

The Effective cost of a loan is determined by adding these upfront charges to the Effective interest.

Step 1: Spread upfront costs like Processing fee, Administrative
Charges and Commitment fee over the loan amount and the loan tenure.

Step 2: If the Charges are quoted in %, spread it over the loan tenure

Step 3: If the charges are in Rs, spread it first over the loan amount and the tenure

Let us understand this with a simple example:

Assumptions

Loan amount Rs 1,00,000 Interest rate 12% Upfront processing charges 0.8% Upfront Administration charges 1% Documentation charges Rs 500

Lets evaluate the results for 1 year and 5 years.

Results

The total cost for the five year tenure is lesser than that for 1 year as the costs get apportioned over the loan period.

Charges   1 Year 5 years Remarks for 5 years Effective Interest 12% 12%   Upfront processing charges 0.8% 0.16% 0.8%/5 years Upfront Administration charges 1% 0.25% 1%/5 years Documentation charges 0.5% 0.10% 500/(100000*5 years) Total Cost 14.3% 12.51%

Fixed and Floating Interest rates

Interest may be fixed or floating. In a fixed rate home loan, the interest rate is constant over the loan tenure. In a floating rate loan the interest rate is linked to a market rate like the bank's lending rate. The interest rate fluctuates with a movement in the bank rate. Floating interest rates are offered at slightly low rates as compared to the fixed rates, as the borrower bears the risk of fluctuations.

If the rates reduce or remain constant over the loan tenure, the borrower shall gain, as the rate under the floating rate scheme will be lower as compared to a fixed rate. Whereas, if the interest rate increases over a period of time, then it could turn out to be expensive, if your lender does not allow you to switch from a floating rate to a fixed interest rate scheme.

The choice ultimately depends on the borrower's perception on the movement in the interest rates in the future. Normally, the tenure of a home loan is more than 10 years. Predicting interest rate movements for such a long period is impossible. A borrower should monitor the savings accruing from a floating rate loan over a fixed rate loan very closely and also the flexibility to switch to a fixed rate at a later date.

In order to help you understand these concepts better, check our tools on Fixed Interest rate, Floating interest rates and Fixed Vs Floating rates.

To conclude: Floating rate scheme could be a better option only if you want a short term loan and are willing to prepay the loan or have the option to switch to a fixed rate loan over the time period.

Repayment schemes, Regular Scheme, Step-up Scheme, Step-down Scheme, Bullet repayments and Home credit scheme

Home loans are becoming very dynamic. Lenders have products suiting people from the age group of 21-65 years. Lenders today give Extended loans upto a period of 30 years, Step-up Plans for youngsters starting out in life. Individuals close to retirement can also avail of short tenure regular scheme or a step-down scheme.

A user can also avail Home credit schemes, wherein the loan can be repaid in half the tenure transacted for by facilitating partial prepayments. Most of the lenders today have done away with pre-payment clauses to permit borrowers to repay their loans earlier. This also gives the lenders liquidity to re-deploy by giving additional loans.

Let us understand the framework of all these schemes in detail:

Regular EMI Scheme: In this scheme you shell out the same amount every month for the loan tenure transacted based on monthly rests or Annual rests. The loan gets reduced to zero at the end of the tenure. Prepayment is allowed and the pre-payment charge is at the discretion of the lender. - Give Demo, same as in E.g. 1

Step-up EMI Scheme: It is seen that many applicants of younger age have no savings to support their own contribution to be invested in a property. Their saving are limited and their incomes are not high. As they are in the beginning of their career, in order to facilitate such applicants to obtain a little higher quantum of loan than they would have otherwise obtained by repayment through standard EMI, They can opt for a Step-up Scheme. Wherein they can step up the monthly installment or graduate the monthly installment on the reasonable assumption that their income will go up every year as they progress in their career. For e.g. lenders like HUDCO assume a maximum of 5% as the increment income for such applicants per annum. Let us understand as to how his loan eligibility enhances under a step-up plan.

Gross Monthly Income- 20,000
Increment p.m. 5%
GMI at the end of the 4th year 23,152
GMI at the end of the 8th year 28,142
EMI expected p.m 35% of GMI
Eligible loan under Regular Plan 5.36 Lakh
Eligible loan under Step-up Plan 6 Lakh

Step down EMI

In order to assist persons nearing the age of retirement, Lenders facilitate borrowers to pay a high EMI till their retirement date and thereafter a reduced EMI. This is the Step down Scheme. E.g. The Step-down Scheme of HUDCO is worked out as under:

Borrowers Age 56 years
Salary p.m. 20000
Retirement age -60 years
Pension expected on Retirement 10,000 p.m.
Eligible loan 336000
EMI payable (1-4 yrs) 6967
EMI Payable (next 5 yrs) 3492

Bullet Repayment

A borrower can avail of a higher loan, if he is in a position to make a lumpsum payment at the time of retirement, from his financial benefits like gratuity or from other sources like FDRs, Debentures, NSC VIIIth issue, LIC Policy, etc. He would be eligible for such a loan by assigning or endorsing any of the above mentioned instruments in HUDCO's favour.

Borrowers Age 56 years
Salary p.m. 20000
Retirment age -60 years
Pension expected on Retirement 10,000 p.m.
Gratuity expected on Retirement 1,00,000
Eligible loan 394000
EMI payable (1-4 yrs) 6967
EMI Payable (next 5 yrs) 3492
Bullet repayment of Rs 1,00,000

Borrower and Co-applicant - Increase in Eligibility

Let us explain this with an simple illustration :

Borrowers income p.m 10000 Co-applicant’s income p.m 10000 Household Expenses  p.m 5000 Loan tenure 15 years Interest rate p.a. 13% Reducing factor Monthly rests

Result:

Let us evaluate both the options, i.e. if the borrower applies in single name or together with his co-applicant.

Single Name Jointly with Co-applicant Income  p.m. 10000 20000 EMI possible p.m. 5000 10000 Loan tenure 15 15 Interest rate 13% 13% Eligible loan (on monthly rests) 395181 790363