Choosing a Loan
There are several features of a Home loan that you must consider based on an analysis of your specific needs. 

How much can you afford? 

As the investment in a home does not yield any monthly income, (unless you have rented out the home) your ability to repay the loan depends entirely on your salary or regular income from a stable business. Finance companies would normally give you a loan to the extent that your monthly repayments are less than 35-50% of your gross monthly salary. 

How much must you leverage? 

Having found a Rs. 10 lac property that you want to buy, you must decide how much of the cost can be funded by a loan. 

Normally Housing Finance Companies will loan you about 80-85% of the property value. You need to make a minimum down payment of 15-20% of the property value. Please also remember that you have to normally bear the following fixed costs before your loan is disbursed: 

1. Processing and administrative fee (1.5-2% both included)

2. Legal fees

3. Stamp duty charges ( for resold property)

4. Property insurance premium

5. Accident insurance premium

Make sure that You have an asset base that is easily converted to cash (e.g. cash in a Bank FD etc.) to cover all charges including down payment. 

As the value of the loan amount increases, the interest rate charged usually also increases. You may feel tempted to take a smaller loan by funding the large down payment (the difference between the value of the property and the loan you have applied for), by withdrawals from other investments. If your investments are in Fixed Deposits that are giving you about 11% p.a (about 7.4% p.a. after tax) and the effective post tax cost of you Home Loan is 10% (about 15% before tax) then this is a good idea. However, if you expect to make over 20% p.a. (about 13.5% post tax) by investing in shares or in a business, then you must borrow as much as you can on the Home Loan and not withdraw money from your other investments.

Another important consideration is your tax bracket and the extent of using available tax breaks. The tax breaks are directly related to the level of interest and principal repayments made each year, with an over all upper limit. You may not qualify for the full tax break if your loan is relatively small. Also remember that the government is keen to give more concessions to the housing sector and the overall cap on tax breaks will go up in the future. It is prudent to lock into a large loan today rather than a smaller one. 

If you have identified other profitable avenues of savings that are expected to give you 15-20% returns p.a, you can use the Home Loan as a way of getting a cheap loan. In this case borrow up to the limit of 80-85% of the property value rather than withdraw cash from the other savings to make the down payment on the loan. 

What is the tenure of the loan? 

Loans are usually for a maximum period of 15 years (which may go upto 20 years in some cases). Longer tenure loans have smaller monthly installments. You can still get a large loan on a relatively small monthly salary by choosing to take a longer period loan. However, longer period loans maybe more expensive (higher rate of interest) even though the monthly installment payment is lower. Convenience always comes at a cost! ………

Statistical evidence also shows that most people take a longer tenure loan of 10-15 years but end up prepaying the same in 5-6 years. This happens because salaries invariably improve with time. There are two costs that could have been avoided through better planing. The first is the Prepayment penalty of 1-2 % and the second is the higher interest rates quoted on longer tenure loan (especially over 20 years). 

In this example, both costs could have been avoided by taking just a 5-6 year loan. 

Further, if you intend to sell the home after about 5-10 years, take a 5-10 year loan only. There is no point paying a higher interest rate for a longer tenure loan of 15-20 years, if you intend to PREPAY the loan in 5-10 years. 

How will interest rates move? 

Till recently you did not have to make this decision as all loans were given on a FIXED RATE basis. This means that the interest rate is fixed for the full tenure of the loan and so is your monthly repayment amount. Life was simple. You could easily plan for the future as your cash flows each monthly after the loan repayments were very predictable. 

However, interest rates in the economy, changes depending on the demand and supply of money. When industry is booming and everyone needs money to do business, interest rates move up and vice –versa. Home loan customers became unhappy about having to pay a very high interest rate that they were locked into, when rates subsequently fell. 

For the customer’s convenience, FLOATING RATE loans were recently introduced. The interest rate on these loans changed every time the interest rate in the financial system changed. The monthly installment falls if interest rate in the economy falls ( HSBC home loan product) . With other companies the monthly installment amount was kept fixed but the tenure of the loan reduces if interest rates in the economy falls ( e.g HDFC floating rate loans). Normally, floating interest rates are quoted in the form of "PLR plus premium". The PLR (Prime Lending Rate) varies from company to company and changes as frequently as once in 3 months. 

Example…… 

A floating rate quote of PLR+0.5% means that interest rate on the loan will change from 14.5% to 15.5% if PLR goes up from 14% to 15%. Also a PLR +0.5% quote from one bank is very different from a PLR +0.5% quote from another as the PLR levels for each may differ. 

In a floating rate loan, the customer gains if interest rates fall, but will take a severe beating if interest rates rise. 

In order to reduce this disadvantage of a the floating rate loan some progressive banks like HSBC have introduced a HYBRID LOAN. In this case a person can decide to fix the interest rate on his loan for periods of 1,2 or 3 years on a long tenure loan and subsequently decide to float his loan. 

For example….. 

You can take a 15 year loan specifying that you will have a fixed interest rate for the first 3 years, after which you have the option to convert to a floating rate loan. If you think that interest rates are about to fall them you will opt for a floating rate loan after 3 years. If interest rates were to rise during the 3 year period you are fully protected as you had locked in a rate for 3 years. 

You will want to stay on with a Floating rate loan as long as you feel that interest rates are expected to fall further. The moment you expect interest rates to start rising, switch immediately to a fixed rate loan. As these changes never happen overnight, you will have enough time to make the move …..provided you watch interest rates carefully. 

This additional flexibility can be capitalised to substantially lower the cost of the loan, often saving as much as 50% of the total interest you may have paid on a simple Fixed rate loan. But……there is a cost ……..the trouble of tracking interest rates and taking a forward looking view on interest rates……

Is there any prepayment penalties? 

Each monthly installment consists of a portion that goes towards repaying the original loan principal and the balance going towards interest on the outstanding loan. If you pay anything over the amount that would go towards principal repayment, the excess amount is construed to be a loan prepayment. Most Housing Finance companies charge a fee of 1-2% on the amount being prepaid. This can be a big disadvantage in several cases. 

1. Your earning capacity will normally increase with age and a prepayment fee deters you from completely retiring your debt before time.

2. Your ability to refinance the loan if interest rates subsequently fall gets constrained

3. You may want to sell the home during the tenure of the loan and you find prepayment costs are an unnecessary burden.

If you may need to do any of the above, choose a loan with no prepayment fees. 

The Total Effective Interest Rate (TEIR) vrs the EMI comparisons: 

It is very important for you to understand the total cost of the loan and try to minimise this cost to the extent possible. As home loans are of a long duration even a 0.5% difference in interest rates can cost you a lot of money over time. 

For example……… 

If you had taken a taken a 15 year loan of Rs. 5 lacs at 15% p.a you would have paid Rs. 31000 less than a 15 year loan of Rs 5 lacs for 15.5%. 

Most of us compare the cost of the loan by comparing the EMI’s (Equated Monthly Installments). This can be misleading as you are ignoring the "time value of money" which means that you need to look at when the EMI is being paid. This is because the value of One Rupee today is vastly different from the value of a Rupee 10 years ago. Using a Discounted Cashflow Model that calculates the Effective interest cost depending on when the EMI amounts are being paid solves this problem.

Other costs that go into the same Discounted Cashflow Model include: 

1. Annual rest, monthly rest, daily rest method of quoting interest rates. The annual rest method of quoting interest rates gives the borrower the credit of principal repaid only once a year although he is paying a portion of the principal in each monthly installment (EMI). A loan quoted with an annual rest interest rate is much more expensive than one quoted on a monthly /daily rest method although the 2 numbers may look identical on paper. 

2. Processing and administrative fees that have to be paid at the time the loan is disbursed.

3. Tax benefits that reduce the total annual repayment.