August 11, 2009 / 9:30 AM / 10 years ago

Cheaper home loans might not be the best

Last week State Bank of India (SBI) announced a further reduction in its home loan rates across different amounts of loans. While this new scheme looks very tempting, there could be more to it than meets the eye.

Labourers work at a construction site in Hyderabad in this May 29, 2009 file photo. REUTERS/Krishnendu Halder/Files

While this might be beneficial to families aspiring to buy homes, we would caution borrowers to understand all aspects of cheap home loan rate schemes from different banks and the process associated with it.

The facts – how do cheap home loan rates work?

The bank has offered teaser rates for the first 3 years, depending upon the size of the loan, below Rs 5 lakhs or above.

During this period, the rate adjusts to a higher amount by about 0.5 percent. Then around the year 4 mark of the loan, the loan gets further adjusted depending upon the then prevailing in-house rate of interest that the bank prices all other loans at.

For example, for loans between Rs 5 lakhs to Rs 50 lakhs, SBI will charge 8 percent in year 1, and 8.5 percent in years 2 and 3. From year 4 the borrower can choose between a floating rate of 2.75 percent below the State Bank Average Rate (SBAR) and a fixed rate of 1.25 percent below SBAR.

There is no way of knowing today what SBAR is going to be a few years from now, because this rate is set internally by the bank.

But, aren’t cheaper rates good for me?

Sure, cheaper rates are good because they result in lower EMI payments. However, this is not all because over time these rates re-adjust upwards and could result in higher EMIs.

Experience has show, particularly during the sub-prime crisis in the US, that those who took low teaser rates to buy homes, tempted by cheap rates were often the ones who ended up in financial trouble a few years later.

This is because when the rates adjusted upwards, they did not have sufficient income to pay the higher EMI.

We are not arguing that SBI is doing a bad thing by announcing low rates and that their actions will result in a crisis. We are just cautioning that these rates should not be as tempting as they appear. And here are some reasons why….

What am I missing?

1. Understand long-term implications: Home loans are long-term borrowings, often with a tenure of up to 10–20 years. So what you should really be thinking about is if you going to be better off in the long-term or not and not just in the first year. Can you afford all the payments during the entire duration of the loan?

Other banks might be offering you a home loan rate where the average rate across the tenure of the loan might be as cheap.

2. Do you understand what the Prime Lending Rate is (PLR): Every bank has an internal interest rate according which all other loan rates are priced. The bank has full discretion to set this rate. Ask your lender to explain to you how the bank’s PLR might fluctuate and how these changes might affect you.

3. Penalty for balance transfer: When you get a loan with a low rate, your flexibility is likely to be restricted. This can hurt you if and when you need to re-finance your loan with another lender that might offer your better terms in the future.

Understand if there will be a penalty for a balance transfer and whether you will be allowed to transfer your balance at all. Could the penalty fees be too high that it offsets any benefit of taking a home loan with a cheap teaser rate? Understand how flexible your lender is going to be.

4. Processing headaches and customer service: Most critically, understand what kind of customer service you can expect from your lender. We have seen enough clients go for cheap teaser rates from banks, only to suffer because either the file is not processed on time or the disbursement is delayed.

Don’t fall for a low rate if you have even a hint of doubt that your loan process will take time. Its not worth putting yourself through the emotional stress that we have seen our clients go through when dealing with some of these lenders.

So, don’t just blindly go in for these cheap loans without understanding the full implications of what you are signing up for.

(For more Personal Finance stories click here)

(Click here for a checklist while taking a home loan)

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