ATM :: Use offset loans to reduce interest costs

Harsh Roongta | May 11, 2015 Last Updated at 00:07 IST | Business Standard


“We are a working couple and looking for a loan of Rs 50 lakh. We can repay the loan in five years time, from our annual bonuses. But, we are being forced to take a 20-year loan as we cannot afford the monthly EMI of a five-year loan”

This kind of query is very common among the young clients I meet. The EMI for Rs 50 lakh loan at the rate of 10 per cent is Rs 1.06 lakh for five years and only Rs 48,000 for 20 years – more than 50 per cent less. With the removal of prepayment charges on floating rate loans, many are able to make lumpsum payments without any prepayment charges and, thus, achieve their purpose of paying off their home loan early.

One solution: There are products called offset loans. Each bank has its own brand name for these products. They are currently available from a limited number of banks, namely, Bank of Baroda (Home loan advantage), Citibank (Home Credit), HSBC (Smart Home), IDBI Bank (Home Loan Interest saver) PNB (flexible housing loan), SBI and subsidiaries (Maxgain), Standard Chartered Bank (Home Saver) and Union Bank (Smart Save).

They work by linking a bank account with your regular home loan account. You can make a deposit and withdraw from this linked bank account like any other regular one. The difference comes at the end of month, when the EMI you pay is split into interest and principal. The average balance in the linked bank account is deducted from the principal loan amount due at the beginning of the month. The interest is calculated on this reduced principal and the balance amount is allocated towards paying off the principal.

Abroad, these kinds of loans are popularly referred to as “offset loans” as the balance is the linked account offsets the home loan amount.

An example will explain this. An offset loan of Rs 10 lakh is available at an interest rate of 10 per cent for a tenure of 20 years In this case, the monthly instalment works out to Rs 9, 650. Let’s the loan is disbursed on April 1.

In the linked current account, you deposit Rs 20,000 in cash on April 11, and another Rs 50,000 in cash on the 21st of the same month and withdraw the entire Rs 70,000 on May 1. The average principal due for April will be Rs 9,70,000, calculated as given below:
Rs 10,00,000 for the first 10 days,
Rs 9,80,000 for the next 10 days and
Rs 9,30,000 for the last 10 days.

The weighted average will be {(10, 00,000*10) + (9, 80,000*10) + (9,30 000*10)}/30 = Rs 9,70,000. The interest component for 30 days in the first month of an instalment amount of Rs 9,650 works out to Rs 7,970 at the rate of 10 per cent on Rs 9,70,000 for 30 days, while the balance Rs 1,680 (Rs 9,650 minus interest Rs 7,970) will be adjusted against the principal. Compare this with the normal break-up of Rs 8,219 towards interest and Rs 1,431 towards repayment of loan under the normal home loan. You can see that the principal gets paid off much quicker in this system though, the money deposited in the linked current account is subsequently withdrawn.

In fact if you do not make any deposit in the linked current account at all, the break-up of interest and principal will remain the same as a normal home loan.

The advantage of this product is that it allows you to use both your temporary and permanent cash surpluses to reduce interest liability on your home loan and at the same time gives you the flexibility of withdrawing the surpluses for other uses, as and when you may require. The linked account is highly recommended as an ideal place for your contingency fund, since it gives you instant liquidity and you effectively earn interest on it at the home loan interest rate.

These loans are normally priced about 0.25 per cent higher than normal home loans, though currently because of competitive pressure, they are available at the same rate as regular home loans especially from foreign banks, major players in this market.

Banks do not push these loans aggressively as they incur an additional treasury cost in terms of managing the liquidity demands. Due to competitive pressures, they are not currently able to charge a premium for such loans. Only foreign banks see this as a marketing opportunity and push the product aggressively but then they are only interested in large-value home loans with ready properties and, thus, address a small portion of the market. Whether you are an existing home loan borrower or a new borrower, this should be your first choice of home loan to shift to or borrow from.

The writer is a registered investment advisor.

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