Is taking a home loan on your mind? Certainly the most important answer you must be seeking would be “how much would be my EMI?” It is a shared concern. Each and every person we know wants to determine what would be the EMI if a loan is taken. This is so because it is the EMI that eventually gets paid from your pocket and directly impacts your planned expenses. To decode your EMI you must understand the factors that affect it.
EMI is a large chunk of unavoidable expense that shakes the root of your financial planning for future. If you are paying an EMI which is greater than what you can afford to pay, given your mandatory expenses, then it can severely impact your critical financials goals such as savings for retirement, child’s marriage and education etc. Therefore, without a doubt EMI is the single most important factor to be considered before you take on the responsibility of a debt.
But now that you have taken a loan how can you manage your EMI? Let us first look at the factors that work behind the calculation of an EMI.
How is my EMI calculated?
Equated Monthly Instalment or more commonly called, EMI, is a function of three primary factors:
Depending on each of these factors, your EMI is determined. With a change in any of these, the EMI changes too. For example, if the amount of loan increases then EMI also increases, which means there is a direct positive relationship between the two. If the tenure increases, keeping the other two factors constant, the EMI reduces, as the same amount of money is spread over a larger period of time.
The primary factor that affects EMI remains to be the interest rate. You can choose the amount of the loan you want, you can pick the number of months or years you want the loan for but you have no control over interest rates. You can never choose the rate of interest that you shall pay. Since this factor is completely beyond your control, it becomes the one factor to watch out for.
Does that mean that home loan interest rates remain constant throughout the tenure and you can do nothing about them? No.
Interest rates are dynamic in nature. There are a number of macroeconomic and microeconomic factors that affect them. Due to this the market rate of lending keeps changing. However, whether your rate will change or not will depend on the terms of your loan agreement. Supposing you selected the fixed rate of interest so it will naturally remain constant throughout the tenure. But if it is floating rate or MCLR linked then it will change from time to time, when the bank revises their base rate.
What to do when interest rates fall?
A lot of people write to us asking what should be their strategy in a falling rate regime. Well the answer to it is simple. It entirely depends on your financial situation at the time. Let us delve into details using an example.
Rakesh Jha took a home loan in 2010 for 20 years for 50 lakhs at 10%. His then EMI was 48, 251/-. In 2015, there was a revision in rates and it was cut down by 1%. So, his new EMI at 9% stood at 44,986/-. In 2017, banks offered Rakesh to link his home loan rate with MCLR. This further brought down his interest rate to 8.5%. And therefore his new EMI was 43, 391/-. To simplify,
Situation #1: Jha decides to reduce the EMI every time the interest rate falls. From 2010 to 2016, he was now saving 4,860/- per month. If he were to keep it in a bank, starting Jan 2017, earning a compound interest every month for the remaining tenure of 13 years, then he would have collected a corpus of roughly 11.4 lakhs (at 6%pa).
Situatiom #2: With a fall in interest rate, Jha agrees to reduce his tenure by a couple of years, keeping his EMI constant at 48,251/- . He would be saving roughly 11.66 lakhs in interest cost. You see, the design of a loan is such that the longer the tenure, the higher is the interest outgo.
Clearly in rupee terms, if the tenure is reduced instead of the EMI, then a person would save more money. But it is subject to a person’s financial position at that time and varies from case to case. Sometimes due to an adversity, one cannot afford a larger EMI, so a fall in EMI frees up some cash for expenses and does not stress the family budget.
At other times, if you are comfortable paying the same EMI inspite of a fall in interest rate then it helps pay off the loan sooner and saves money in terms of total interest paid.
It is advisable to always calculate your EMI beforehand. You could use any online home loan EMI calculator to measure a rough figure on how much money you would be paying every month if you take the loan.
It is difficult to peg an unfailing answer on what you must do for sure as it is subjective to individual circumstances. However, what you must certainly do is study all your options and take an informed decision.
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