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B. Venkatesh

BANKS and housing finance companies have cut interest rates on their home loans. These companies are touting that now is the best time for people to take cheap home loans. Yet, deciding the right time to take home loans is not easy. The reason?

Suppose you decide to take a 20-year home loan now from LIC Housing for Rs 5 lakh at, say, 12 per cent. What if two years later, the company cuts its rates to 11 per cent?

Since your loan is for a large amount and for a longer period, even a 1 percentage point cut in rates could make for substantial savings.

You would, therefore, want to close the earlier loan and borrow afresh at lower rate. But you cannot do that because prepayment of existing home loans is not quite encouraged.

You are, therefore, stuck with the initial rate (12 per cent in the above example) on your home loan even if the prevailing rates are lower. This lack of exit opportunity makes it very difficult to time home loan purchases.

But why do companies discourage prepayment of home loans? The reason is that these companies run a reinvestment risk. This is the risk of having to reinvest the prepayment proceeds at a lower rate.

Now, home loan prepayments occur only if interest rate falls. In the above case, you decide to prepay because the rates have fallen by 1 percentage point.

But what will the company do with the money that it receives from you by way of prepayments?

It can lend the money at only prevailing rate of 11 per cent. The company, thus, loses 1 percentage point interest because it allowed you to prepay your loans.

To prevent such loss in revenue, companies discourage borrowers from refinancing their home loans. This the companies do by charging stiff penalties for prepayments or by explicitly prohibiting prepayments before a certain period.

So, take a loan if you want to buy a house, but do not expect to perfectly time your home loan purchase.

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