Should home seekers put off buying a house because of high interest rates?

The series of rate hikes has resulted in the EMI on home loans going up by more than 20% to Rs1,016 on every one lakh rupees. However, with rates having climbed so high, it would not be wrong to assume that any further increases should be very limited

The past 12 months have seen interest rates on home loans rise from 8% to 10.75%. This has resulted in equated monthly installments (EMI) going up by 21% from Rs837 for every one lakh rupees on the loan to Rs1,016. The question facing home buyers today is whether to go ahead and buy a house if and when real estate prices do decline, or wait till interest rates drop too. Before we answer that, let us understand why interest rates increase or decrease and what the long-term implications are for home buyers.

Interest rates in India are largely a function of the monetary policy, which is decided by the Reserve Bank of India (RBI). The RBI has several goals; the most difficult of them is to maintain a balance between the need to ensure economic growth and control inflation. When inflation rises and threatens to spin out of control, as it has today, the RBI 'tightens' monetary policy. This amounts to reducing, or making expensive, the money supply in the economy.

The RBI achieves this by either increasing the repo rate (the rate at which banks borrow from the RBI) which increases borrowing costs, or increasing the cash reserve ratio (CRR) which has the effect of reducing money supply in the economy. Though the RBI's policies could take up to a year to have their full intended impact, they are perhaps the most effective way to reduce inflation.

The RBI has increased repo rates nine times in the past 12 months, from 5.25% to 8%, towards curbing stubborn inflation. This has resulted in an increase in the base rates of banks and the prime lending rates (PLR) of housing finance companies by 2.5%-3%. Consequently, home loan rates have increased from around 8% per annum to 10.75% and the EMI has shot up by 21%.

This increase in EMI impacts buyers' budgets and often persuades them to wait for the interest rates to come down. As almost all home loans are offered on a floating rate basis, the interest rates applicable would increase in line with rising interest rates. This would mean that even if you had taken a loan at 8%, the current rate would be 10.75%, and either the EMI would have gone up or the tenor (repayment period) of the loan would have increased. Clearly, home-buying decisions should not be influenced by the level of interest rates prevailing at the time of the purchase of house.

However, there are long-term implications for home buyers who take a mortgage, since interest rates are cyclical in nature (illustrated below by repo rate movement over the past six years).

Interestingly, when interest rates are high, there is a smaller probability of a further increase in the interest rate, and thereby a lesser risk of the burden of an increase in EMI. Conversely, in a low interest rate environment, the risk of a subsequent increase in interest rates, leading to a bigger EMI burden is higher.

The correct strategy, especially in a low interest rate environment, would be to assume that interest rates can go up by as much as 2%. Interest rates have averaged 10% over the past 10 years for home loans and hence the assumption of a 10% interest rate is a good thumb rule to calculate your repayment capacity.

The tax benefit available on housing loans is an important consideration since it reduces the effective cost of borrowing. As illustrated (below), the effective cost of borrowing is still below 8% for an average home buyer.

In conclusion, current high interest rates should not deter one from buying a house, but it would be wise to keep some cushion in one's borrowing capacity, to provide for increases in interest rates and the consequent increase in EMI.

(Gagan Banga is a writer and CEO of Indiabulls.)




5 years ago

this information is very useful for home loan tatker

Govind Shanbhag

5 years ago

Gagan jee - Buying a house for many is an impulsive decision. For the last 2-3 years I have been hearing the rate is coming down which has not happened. Many of house buyers they dispose off existing house buy a new one, adding extra space, room and/or in improvement in area. In such an event, the house which they are now disposing off will also command lesser rate. One thing is sure, due to slow down in redevelopment of old buildings, the rentals in suburb has come down marginally.

Samarth Singh

5 years ago

The writer does not take into consideration the purpose behind the purchase of a house i.e. whether it is an investment or a first-home purchase.

The reasons for a first-home purchase can be numerous and the timing is really dependant on personal reasons, preferences, needs and wants.

In the case of a purchase made as an investment - the interest rate environment is irrelevant. What really matters is the expected yield on the investment. A purchase made at a higher than normal yield will be reflected in substantial capital gains in the future and vice versa.

A high interest rate environment simply increases the possibility of being able to purchase a property (or any other asset for that matter) at an attractive rental yield.

Another way to think about this is if you consider purchasing a piece of real estate as investment without a mortgage. In this case, interest rates are irrelevant to you. The only thing that should matter is if you are getting a good return (in terms of rental yield) on your investment vis-a-vis other investment opportunities available to you.

On another note - as I have mentioned above, a good return on investment should be measured by rental yield and not by at what price you expect to sell to the next fellow. The greater fool's theory (i.e. let me buy today because a greater fool is going to buy from me at a higher price tomorrow) is a fine form of speculating but not an intelligent form of investing.

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