The 8% interest rate lure: how good is it?

The current hot trend in the home loans segment is the fixed-cum-floating interest rate schemes crowding the loan marketplace.

The magical 8 per cent home loan scheme that first came into being sometime in the beginning of this year has created quite a stir in this segment and quickly became a sort of benchmark to promote discounted festive loan offers even below this rate for the first six months to a few years of the loan tenure by various banks. After this time period, it reverts to the prevailing floating home loan rate in the market.

Let us consider the factors involved in this type of interest rate scheme and its implications.

First-time home buyers will be tempted to buy a house right now as the property prices have also dipped and the market is in recovery stages now. In an effort to revive the realty market and the lending market which had seen a slump in the not so recent past, such loan offers could seem the ideal bet.

However, as a loan applicant you need to evaluate if it makes sense for the home buyer to opt for these fixed cum floating rate loan offers. Also, should existing home loan borrowers shift to this apparently attractive loan rate scheme?

To understand how relevant it is for a new home loan customer and an existing home loan borrower who wishes to transfer his home loan to another bank offering a fixed-cum-floating interest rate scheme, let us first mull over the significance of the savings from these offers over time. Is the offer indeed attractive like it appears upfront?

Let us consider an example to understand this better. Banks will provide an amortization table, which will help you calculate the costs involved. Please note interest rate projections in the calculation are just an indication and may not be what it translates to in reality -- could be less or more.

A fixed cum floating rate loan offer:  Rs 30 lakh (Rs 3 million) for 20 years at 8 per cent interest rate frozen for the first year and then follows a floating home loan rate of 10.25 per cent.

For the first year at a frozen rate of 8 per cent the money outflow on the loan : Rs 3 lakh (Rs 300,000).

After one year when the interest rate is changed to the current floating rate of 10.25 per cent: Rs 66.8 lakh (Rs 6.68 million)

Total money outflow over 20 years + Processing fee Nil = Rs. 69.8 lakh (Rs 6.98 million)

Total Interest paid out for the loan:  Rs 39.8 lakh (Rs 3.98 million)

An existing floating loan offer : Interest rate of 9.75 per cent for the same loan amount of Rs 30 lakh (Rs 3 million) and tenure of 20 years and a processing fee of 1 per cent of the loan amount, which is Rs 30,000.

Total money outflow over 20 years = Rs 68.3 lakh + 1% processing fee (Rs 30,000) = Rs 68.6 lakh

Total interest paid out for the loan = Rs 38.3 lakh

So opting for a pure floating rate loan will actually offer you a saving of Rs 1.2 lakh (Rs 120,000), even after including the processing fee.

This example makes it clear that the interest rate scheme where 8 per cent is frozen for one year, may not  actually be as profitable as it appears upfront. In fact you might save more opting for a home loan, which is a little bit higher than the 8 per cent scheme offered.

This article is a sample case study stressing on the fact that one should look beyond introductory offers to arrive at the actual total loan cost to truly compare various home loan offers from banks.

In this instance, it is clear that an introductory offer of 8 per cent for a year in a 20-year floating home loan rate need not necessarily be better than a 9.75 per cent or an 8.75 per cent floating home loan rate, with other conditions being constant.

This is subject to the fact that when the floating loan rates are revised periodically -- they should not differ too much between the various banks, which will again affect how the total loan cost between banks differ.

One also needs to consider, will there be better or more expensive offers after a while on both the property prices and home loan interest rates that you can either gain from or lose out on by taking up this offer?

These and more questions that may arise need to be given thought, apart from total loan cost before you consider taking up such loan offers.