Unease awaits teaser-rate borrowers

The Reserve Bank of India (RBI) has recently expressed concern about the teaser loan rates.

“In the area of housing loans, teaser rates are increasingly being offered which is a cause for concern. I hope banks are ensuring that borrowers are well aware of the implications of such rates and the appraisal takes into account repaying capacity of the borrowers when the rates become normal,” RBI deputy governor Usha Thorat said at the Bancon on Tuesday.

The point being made was that when the “teaser rate” period is over (2-3 years in most cases) and interest rates shift to the normal floating rates prevalent at that time, the consumers may not be able to cope up with the resultant increases in EMIs, especially if, as widely expected, interest rates go up significantly in the meanwhile.

I give a small calculation here for the better understanding of the ‘teaser rigmarole.’ Take the case of a typical 30-year-old salaried person with a net salary of around Rs 40,000. As per the eligibility calculations he would be able to get a loan of Rs 20 lakh from the State Bank of India (SBI).

If he went for the normal option of regular floating rate loans, he will get an interest rate of 8.75% (EMI per lakh of Rs 884) and will also be eligible for a similar loan amount of Rs 20 lakh.

Let’s run a simulation to see what happens if the interest rates rise by 2% in 2010, 1% in 2011 and another 1% in 2012 —- or a total of 4% in the next 3 years. In the case of the SBI home loan, the interest rate from the fourth year goes up to 13%. Had the person gone for the floating rate loan, the interest rate would be 10.75% (original rate of 8.75% plus 2%) in the first year, 11.75% in the second year and 12.75% for the period after that.

The instalment-to-income ratio in both cases go up sharply from 44% to 57% (indicating that a larger proportion of the income will go towards servicing the home loan) at the end of three years and in both cases are almost at the same levels. This means irrespective of the type of loan, the degree of difficulty in repayment would be similar in both the loans if rates increase steeply by 4% over 3 years. In both cases, an 8% annual increase in income will ensure that the instalment-to-income ratio remains at the original levels.

Of course, in the regular floating rate loan, the consumer ends up paying for the increase in interest rates in the first 3 years also. This increase will ensure that the instalment-to-income ratio falls back to the mid-40 levels that are considered safe by Indian standards.

So, whether the consumer chooses the “teaser rate” product or the regular floating rate product, he would face some difficulty if interest rates rise steeply as the IIR will increase to uncomfortable levels of 55%+. The IIR can fall back to reasonably comfortable levels if net income rises by 8% per annum, which should not be a big issue if our overall economic growth does not falter.

What would perhaps help both banks and consumers is putting in place a transparent regime to ensure that increases in interest rates (and decreases for that matter) are worked out on a transparent and objective basis so that consumers are better prepared for such increases and the actual increase doesn’t come as a shock to them as might be the case around 2013.

The writer is CEO, Apna Paisa, a search and comparison engine for loans, insuranceand investments.