Update Date : 18-Oct-2023

Created Date : 18-Oct-2023

Reference : ET Wealth

Want to invest in stocks but don’t have the money? Why not go for the margin trading facility that brokerages offer? You can buy stocks by paying only 15-20% of the transaction value. The brokerage house charges about 9-12% interest on the margin provided, but surely you can earn more than that from investment in stocks. It’s a terrific way to make money. Or is it? Before you jump in, note that while margin trading can give you gains from the money you didn’t have, it can also be ruinous if the stocks don’t move as expected.
 
If the stocks you buy decline, you not only suffer a capital loss but also end up paying interest on the margin. The dreaded margin call from the broker will force you to exit at a loss. ET Wealth has consistently warned investors that borrowing to invest is not a prudent strategy. It is especially risky when you are buying volatile assets that can fall in value. Even buying a second house with borrowed money may not be a good idea. The House Price Index of the RBI shows that home prices in many cities across India have registered a CAGR of less than 6% in the past 10 years. In other words, buyers may have paid 7-8% on a loan to purchase an asset that rose 5-6% in value.
 
Our cover story looks at smart ways to borrow and offers tips to those planning to take a loan. We also tell you about the tricks that lenders use to lure customers.
 
 
LOOK BEHIND THE RATE OFFERED

One common trick is pitching the flat rate of interest. You will be told that the lender will charge a flat rate of 9% on the loan amount. This is a flawed calculation because every EMI reduces the principal outstanding. The correct calculation would be on the reducing balance. If the loan is for three years, a flat rate of 9% effectively works out to 16.3% on a reducing rate of interest. Here again, a borrower should look at the calculation used for reducing balance. A daily reducing balance rate will be higher, but works out to be a better option (see column on page 4).

Then there is another hidden cost in the form of a processing fee. This is usually 1-2% of the loan amount but capped at around Rs.1,000. If you factor in even a 2% processing fee, the effective rate will go up further to 17.7%. Many lenders also insist on 1-2 advance EMIs, which will push the effective rate to more than 20% (see graphic). Unfortunately, customers usually don’t pay attention to these details when the loan is being disbursed. They are more concerned about the disbursed amount and don’t look at the fine print of the loan agreement. They sign on the crosses on each sheet so that they can quickly get the loan.
 
 
WHENEVER YOU CAN, PREPAY LONG-TERM LOANS

There’s a joke that if you don’t love your job, take a big home loan. The EMI will change your views about your job, the workplace and possibly even your boss. This might make some people smile, but for millions of borrowers, their home loan EMIs are no laughing matter. The flurry of rate hikes last year pushed up home loan rates by almost 250 basis points. The RBI hit the pause button on rate hikes in February, but the high home loan rates have led to extended tenures of existing loans. A 20-year floating rate home loan taken in April 2022 when the rate was 6.7% will now be repaid over 43 years.

Such tenures are unreal for many people because they extend well beyond their working life. Two months ago, the RBI directed lenders not to extend loan tenures, but to give borrowers the choice to increase their EMIs or make a part payment to counter the impact of the increase in rates. If your lender has increased the loan tenure, get it to increase the EMI instead. It will keep the interest outgo within limits. You could also make a prepayment to bring down the loan tenure. With home loan rates touching 9%, prepayment of outstanding loans could be the best investment right now for those with long-term loans.
 
RISHI PIPARAIYA
FINANCIAL MENTOR AND AUTHOR
 
Note: “Lenders make it easy to take a loan but place hurdles when you want to prepay it. Understand the prepayment rules when you take a loan. ”
 
 
HOW 9% CAN BE MORE THAN 20%

DON’T LET THE BANK EXTEND YOUR LOAN TENURE

The rise in home loan rates has upset the calculations of long-term borrowers.
 
• Till now, the default option was to extend the loan when interest rates went up.
• RBI has now directed lenders to give borrowers the choice to increase EMIs to retain tenure.
• Borrowers can also make a part prepayment to reduce the Floating rate outstanding amount.
 
“It’s a good idea to liquidate other fixed-income investments to pay off the loan. If your fixed deposit is earning 6-7%, it’s better to foreclose it and use the proceeds to retire the 9% home loan,” says Raj Khosla, Managing Director, MyMoneyMantra. However, prepayment is not as easy as it may sound. Though the RBI has directed banks not to charge prepayment penalty on floating rate loans, banks still find a way around this (see box). “Make sure you understand the prepayment rules when you take a loan. Lenders make it easy to take a loan but place hurdles when it comes to prepayment of the loan,” warns Rishi Piparaiya, financial mentor.
 
 
MAKE IT SHORT AND SWEET

Experts suggest that the loan tenure should be as short as possible so that the interest cost is low. Sometimes it becomes necessary to go for a longer tenure to fit the EMI into a tight budget. If you are forced by circumstances to take a home loan for the long term (15-20 years), try and increase the EMI amount every year in line with the increase in your income. Increasing the EMI amount can bring down the tenure dramatically. A 5% yearly increase in the EMI of a 20-year loan will reduce the tenure by more than eight years. Increasing it by 10% every year would end the loan in less than 10 years. Keep in mind that prepayment has a bigger impact when the loan is new. If you have taken a 20-year loan and prepay 10% of the outstanding amount in the second year itself, the loan tenure will be reduced by 42 months.

 
RHISHABH GARG
 
HEAD OF TERM INSURANCE,POLICYBAZAAR.COM
Note:“Mortgage covers are sold along with home loans. A regular term plan is a better option than a policy linked to a loan.”

 

TAKE INSURANCE COVER AGAINST UNEXPECTED EVENTS

An individual takes a loan because he is confident of repaying it, but circumstances can sometimes go out of control. When taking a big-ticket loan, consider taking a life insurance policy to cover the amount in case something untoward happens to you. It doesn’t cost too much (see graphic) but will prevent financial distress for a family dealing with the emotional turmoil of losing a member.
 

COVER BIG-TICKET BORROWINGS WITH LIFE INSURANCE POLICY

Here is the cost of Rs.50 lakh cover for 20 years.
 
Some lenders tend to slip in a mortgage cover along with a home loan. These are single-premium policies that cover the borrower and pay off the loan if he dies. The death benefit is linked to the loan and progressively comes down as the outstanding loan reduces. “They are bundled products and sold in a closed environment by banks and other lenders. Sometimes the customer doesn’t know that he has been sold insurance along with his home loan,” says Rhishabh Garg, Head of Term Insurance at Policybazaar. com.
 
Since mortgage cover is not available off the shelf, it is impossible to compare their premiums with regular term plans. However, Garg says a regular term plan is a better option than an insurance cover linked to a loan. In a regular term policy, the cover is not linked to the outstanding amount and will continue even after the loan has been paid off. In a mortgage cover, if the borrower decides to shift to another lender, the cover could end because the policy is assigned to the original lender.
 
 
DON’T BUY A COVER LINKED TO LOAN

A regular term plan is a better option. Here is what a Rs.50 lakh cover will cost a male buyer aged 35 years.

In the end, just keep this simple rule in mind: Don’t take a loan just because it is available. ‘Buy now, pay later’ companies have made it very easy for people to spend borrowed money. “One needs to differentiate needs from wants. Borrowing money for a car or a house to live in is a need. Borrowing to buy a bigger car or a second house in the hills is a want. Don’t give in to impulses,” says Piparaiya. Readers will do well to keep this in mind when they go shopping during the festive season.
 
RAJ KHOSLA
MANAGING DIRECTOR,MYMONEYMANTRA.COM
 
Note: “It’s a good idea to liquidate other investments to prepay a loan. If FDs earn 6-7%, it’s better to foreclose them and retire the 9% home loan.”

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