Of home loans, EMIs and property insurance

The monthly payment for a borrower is not just the EMI. Borrowers have to get their homes insured too

The property acquired is the collateral for the loan. Unlike in India, where property prices usually go up steadily, in western countries it is an asset whose prices oscillate with economic conditions, just like stock prices.
The property acquired is the collateral for the loan. Unlike in India, where property prices usually go up steadily, in western countries it is an asset whose prices oscillate with economic conditions, just like stock prices.

By Sunil Parameswaran

In earlier days, the normal practice was to save money, and buy a home just before retirement, or at the time of retirement. In fact, most people would use their provident fund to acquire a home. Government employees would use this money to acquire a home, and then depend on their pension income for other expenses. Those who were supported by grown-up children, had another source of support.

Today people in their early 20s take housing loans. A home loan is an amortized loan. That is, it is paid back in the form of equal, usually monthly instalments. Hence, the word EMI. The present value of all the EMIs is the loan amount. Each EMI consists of a part payment of principal, and interest on the outstanding balance. Since the outstanding balance is steadily decreasing, the interest component of the EMI will steadily decline, while the principal component will steadily increase.

Calculating EMI
The sum of the two, which is the EMI, will remain constant. Thus, if a person were to take a 15-year loan, in the initial years, the EMI will consist mainly of interest payment. Towards the fag end of the loan, the EMI will consist mainly of principal repayment. This may sound very logical, but lenders in the US learnt a lesson the hard way. About 75 years ago the practice was to make 360 month or 30-year loans, where the first 359 payments consisted of only interest, and the entire principal was repaid at the end of the loan. Needless to say, there were major defaults. Then someone thought that a method ought to be devised to recover the principal in instalments right from the outset, and the result was the creation of amortized loans.

The property acquired is the collateral for the loan. Unlike in India, where property prices usually go up steadily, in western countries it is an asset whose prices oscillate with economic conditions, just like stock prices. Thus, to acquire a property with a price of dollars ‘X’, the borrower cannot get 100% financing.

They would have to make a down payment or margin payment, and the balance can be borrowed. The ratio of the amount borrowed to the market value of the home is called the Loan to Value or LTV ratio. The lower the ratio, the greater is the margin of safety for the lender. Lenders also look at what is termed as the ‘Payment to Income’ or PTI ratio. This is the ratio of the monthly payments due to the monthly income of the borrower. The lower the PTI ratio, the more the reassurance for the lender.

Property insurance
The monthly payment for a borrower is not just the EMI. Borrowers have to get their properties insured to protect against unforeseen events. Also, property taxes have to be paid every year. In practice, lenders require borrowers to contribute to an escrow account. Once this is done, it’s the responsibility of the lender to make the statutory payments on time. Property insurance is insisted upon by most lenders.

Borrowers will also be worried about the spectre of their family members having to vacate the property, in the event of a calamity. It is possible to acquire an insurance policy that will enable the family members to continue making the EMI payments, even if something were to happen to the borrower. In the US, it is called credit life insurance.

The writer is CEO, Tarheel Consultancy Services

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