Money Plants

Tuesday, February 21, 2006

The truth about home loans

The first truth: Your fixed rate loan may not be really fixed
Banks can word their loan agreements quite smartly. If you have taken a fixed rate home loan read the fine print carefully. Some agreements have wordings that say that while your loan is at a fixed interest rate, banks have the free will to increase the rate in case of any unforeseen circumstance. The banker will never tell you what 'unforseen' really means. These loans are also called money market loans.

So if you are taking a fixed rate home loan, make sure you know what it is. While a money market loan is not a bad product, make sure you are not tricked into believing that you got a completely fixed loan.

The second truth:
Your floating rate loan isnt really floating
Floating rate loan theoretically means that your interest rate is linked to an internal benchmark of the bank such as the Prime Lending Rate (PLR). Your floating rate of interest should ideally change if the PLR changes. Or at least, that's what the banker will tell you. This link between the home loan rate and the PLR is only the partial truth. What really happens is slightly different. There is a hidden clause of ‘spread’.

Spread is the difference between the PLR and the home loan interest rate and is unique to each home loan agreement. In case of home loans, the spread is negative, which means, the home loan interest rate is offered at less than the PLR. What banks do is change the spread and not the PLR.

For example, let's say PLR is 10% and spread is 1.5%. Thus, your interest rate is PLR minus spread which is 8.5%. Suppose interest rates in the economy fall. Now the bank announces interest rates to new customers at 7.5%. Now this does not mean that the loan you took at 8.5% will also reduce interest rate to 7.5%. Banks will only change the spread from 1.5% to 2.5% in case of new loans. Thus while new loans are at 7.5%, you will still pay 8.5% because the PLR hasnt changed.

The third truth: The benchmark itself is faulty

Each bank sets its own benchmark, or PLR, for the floating rate loan. PLR is not an external benchmark. It is something that the bank sets on its own. So really, it is in the control of the bank and not related to how exactly interest rates move in the economy.

While taking a home loan, make sure you read all the fine print. Contrary to popular belief, the language is not difficult to understand. It just need a bit of patience.