Remember stories in books and films where a villager could never pay off his debts to the village Mahajan (moneylender) because of high interest that kept compounding? Well, the rising interest rates in the country today have brought this debt trap literally to households’ doorsteps.Up 3 percentage points over the past one and half years, the floating rate of interest on home loans has hit a high of 11 per cent from 7.5-8 per cent. Such a high rise in such a short period has brought with it memories of the Mahajan — if banks and housing finance companies do not increase the EMI (equated monthly installment), it becomes insufficient to cover even the interest component. A household that can’t take on a higher EMI will theoretically end up paying in perpetuity.Here’s why. There are two components involved in an EMI payment for any loan — interest and principal. In the initial years of loan repayment, most of the money goes towards paying interest and the principal outstanding remains high. In the latter half of the payment schedule when much of the interest has been paid, the principal gets reduced and principal repayment increases.In a rising interest rate regime like today’s, banks have the ability to increase tenure only upto a point. Beyond that, if the interest rate continues to rise, the EMI becomes insufficient to cover the loan (interest and principal) and banks are forced to increase the amount of EMI as well.An illustration. Suppose Rakesh Garg took a 20 year floating rate home loan of Rs 20 lakh at 7.5 per cent in September 2005. His EMI for the loan would be Rs 16,111. During the next 18 months he would have paid a total of Rs 290,013 as EMI, of which Rs 221,428 (or 76 per cent) would have gone towards interest payments and just Rs 68,585 (24 per cent) towards principal. He’s still left with Rs 19,31,415 to be paid towards his principal.Now, as interest rates rise, his tenure rises too. At 8 per cent his 20 year tenure rises to 21.6 years, at 9 per cent to 27.1 years. After this, the rise in tenure is very steep — to 33 years at 9.5 per cent, almost 40 years at 9.75 per cent and to more than 70 years at 10 per cent (See chart on page 2).If interest rates rise beyond 10 per cent, the scope for increasing tenure ends. At 11 per cent, the current rate, with Rs 19.3 lakh of principal to be repaid, the interest component for the 19th month stands at Rs 17,704. That is, Garg’s Rs 16,111 EMI is short by Rs 1,593 — and we’re not taking principal into account. This Rs 1,593 gets added back to the principal and like all debt traps, Garg will end up paying till perpetuity. The way out: banks have to increase EMI along with tenure. In Garg’s case, if the bank decides to increase his tenure from 20 years to 30 years (if, that is, in the banks’ opinion, he has that many earning years ahead), his new EMI rises by Rs 2,405 to Rs 18,521. In other words, Garg will now have to pay Rs 18,521 for the remaining 28.5 years, instead of Rs 16,111 for 18.5 years.“It is true that increasing the tenure in itself has not been able to take care of the rise in interest rate and so we have been increasing the EMI’s too since July 2006,” says Rajeev Sabharwal, head (retail assets), ICICI Bank. “We increase the tenure looking mainly at the earning age of the customer which varies from 60-65 though we also look at the initial loan tenure.”This has implications on total cost of the house too. Garg’s total outgo (the sum of principal and interest) for the Rs 20 lakh loan, which stood at Rs 38.6 lakh when the interest rate was 7.5 per cent, will now rise to Rs 66.2 lakh, a steep jump of 72 per cent. (For the sake of simplicity we have not calculated the interim rates.)Now zoom out of Garg’s problem and see why this is happening. The culprit is inflation and its control through increasing interest rates to squeeze demand. Except that inflation is high because of under supply rather than excess demand. The solution is for municipalities and states to let go of land and allow development. That happens anyway through the mushrooming of badly built, poorly infrastructured illegal colonies, run illegally, and given political patronage. By freeing land for development, the government will allow honest citizens to buy houses. Asset inflation will be under control and prices — and EMIs — affordable.Inflation is likely to start falling in May. Then, logically, the numbers should start reversing. But that will happen only if banks pass on the benefits of falling rates to consumers. Currently, most banks’ floating rates are benchmarked arbitrarily and are not independent. So, fears of these benefits not being passed on to households is very real — something that Reserve Bank of India (RBI) needs to focus on.Meanwhile, the aam aadmi, who finally got a shot at owning his house early in life, will have to start cutting down his other spends. As a senior banker said while talking about non performing assets, “People will cut on everything to pay their EMIs, they are the best borrowers. They will not default, they will pay.”
