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Suresh Krishnamurthy

IT IS NOW more than a year since the interest rate honeymoon ended for Indian borrowers and banks. While the interest rate on government securities has since edged up by about 1.5 percentage points, thaton home loans has not gone up by as much — about 0.25 percentage points for most borrowers. This could, however, rise further. Those who opted for floating rates will have little option but to grin and bear it. There are no effective hedges against rising home loan rates.

In addition, the option of conversion to fixed rate loans does not appear attractive. Given the conversion fee and the higher interest payable on fixed rate loans, conversion will be attractive only if interest rates rise beyond 9.5 per cent and that, too, quickly.

Since the probability of such an increase in home loan rates appears low, the case for conversion is weak for all but the most conservative minded. Such a person would anyway not have gone in for a floating rate loan in the first place.

Crystal ball gazing

The rupee has been edging higher against the dollar lately. Experts say that this trend of the rupee and other currencies rising against the dollar indicate that for the time being global interest rates may have stabilised.

Falling dollar value obviates the need for any increase in interest rates in the US. Even otherwise, some economic pundits have predicted that US interest rates may not increase from their current levels for some time to come.

If interest rates in the US do not rise, then there would be less upward pressure on Indian interest rates.

In addition, for Indian banks, the cost of funds has stayed at about 5 per cent even as at end-March 2005. Home loans with interest rate of 8 per cent and above offer attractive spreads of 3 per cent or more to these banks. With defaults on home loans being lower than that on other loan products, there is less justification for jacking up interest rates for existing borrowers.

It is, however, quite likely that cost of funds will rise for banks in FY 2006. In this context, despite stable global interest rates, the likelihood of a further 25 basis point increase in interest rates for existing home loan borrowers before the end of the year appears almost inevitable.

Most banks may do it just to enhance their revenue lost on other loan products, where competition is now starting to intensify.

There is also the wild card in the form of oil prices. There are reports that predict oil prices will hit $60 in 2006, $70 in 2007 and rise further to touch a high of even $100.

Let alone such a meteoric rise, if oil prices cross $60, then Indian interest rates will rise by a bigger margin.

Costly conversion

Given the upward interest rate bias, you may be thinking of converting your floating rate loan to a fixed rate loan. But that may not be such a lucrative option. This is because of the conversion fee and the higher monthly instalments on a fixed rate loan. Higher monthly instalments would become payable on fixed rate loans because fixed interest rate is higher than floating interest by at least 0.50 percentage points. This cost may work out to be higher than the benefit obtained.

Suppose you are paying a floating rate of 8 per cent per annum now and that it is three years since you took a 15-year loan. For a shift to a fixed rate loan of 8.5 per cent, you may have to pay a conversion fee of 1.75 per cent. The fee is applicable on the principal outstanding. In addition, your monthly payments would rise by 2.6 per cent.

Also consider the following interest rate path:

floating rate rises by 0.25 percentage points immediately;

thereafter it rises by a further 0.25 percentage points every year for the next three years; and

stays at the 9 per cent rate thereafter.

In this scenario, the rate of return for costs incurred (conversion fee and higher monthly payments) works out to less than 4 per cent. If the conversion should benefit the investor, then the interest rates should rise to 9.5 per cent or higher over the next three years.

There are a few other factors too:

It may be difficult to transfer to a fixed rate of 8.5 per cent now. Banks may demand 8.75 per cent for a loan that is fully fixed for its tenure. For instance, ICICI's fixed rates loans on offer are at 8.75 per cent. This will reduce the benefit from conversion substantially.

Interest rates could fall after five years which would once again potentially reduce the benefit.

SBI charges a conversion fee of, hold your breath, 3.85 per cent. Borrowers from SBI thus have no option but to give up on conversion. The fee of 1.75 per cent referred above is charged by ICICI and HDFC. LIC Housing Finance charges a conversion fee of 2.25 per cent. LIC Housing Finance would also reduce the tenure of the loan to ten years, if the period remaining were higher. The benefits from conversion would be significantly reduced.

Conversion — for whom?

As such, conversion would not make financial sense for most home loan borrowers who have taken floating rate loan and are paying below 8.25 per cent.

However, the financial benefits calculated do not include the value for insurance. Yes, indeed, there is a cost to insurance.

Conversion would protect you in the event of an extraneous event, which triggers a steep rise in interest rates. If you have such a fear and do not mind the extra cost associated with fixed rate loans, conversion is for you.

In addition, if you are paying a floating rate of 8.5 per cent and can convert to a fixed rate home loan of between 8.5 and 9 per cent, it would make eminent sense. Conversion for such borrowers would be a lucrative proposition.

Else, you would have to stay put and hope interest rates do not rise beyond 9 per cent. At present, those paying a floating rate of 8 per cent or lower, a rise in their home loan rate beyond 9 per cent appears remote. Given the associated costs, they can postpone the need for conversion by another six months or possibly one year.

Alternative hedge

Besides this, those who can afford should seriously consider buying futures on crude oil. Rising crude oil will have the biggest impact on interest rates.

If you buy crude oil futures, the profit on futures can to an extent offset the impact of rising interest rates. Most, however, may not be able to buy them.

Another option would be to buy the stock of private sector banks and housing finance companies such as HDFC and LIC Housing Finance.

Rising interest rates would benefit this segment and possibly lead to a gain in the value of your holdings.

Both options may not protect you fully in the event of rising interest rates. This is especially given the size of the loan. They may however help in making you feel better.

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