Podcast | Digging Deeper with Moneycontrol - Freedom from the terror of monthly EMIs

It’s independence week here on Moneycontrol, and we’ve been looking at the various ways financial independence can lead to a real sense of freedom for individuals. It is said money can’t buy you happiness, but that has never stopped anyone from trying, has it? In fact, we have come around to believing that money can get you to a place where you can make the choice to be happy... or something like that.

Financial freedom always brings one thing to mind - our lack of it. For a large majority of Indians, buying a house is one of the biggest dreams and motivations. For a big chunk of that majority, the dream can turn sour somewhere down the line. The financial assistance they signed up for to help buy the dream house, takes a heavy toll on the budget and other life goals. We spend out the first week of every month paying high insurance premiums, expensive personal loans and car loans, calculating the interest on our investments etc. And it is just rinse-repeat every month. Such an existence can quickly become a drudgery which is going nowhere as life passes us by rapidly.

Today, we’re going to examine a few ways that we can get free from such stress. What can a person do to control, and streamline, his or her finances in such a way that they never have to worry about it?

It is also true that we live in times of ever-increasing inflation. It is not easy to plan our savings. Prices are always going up, and this forces us to spend more of our income on daily living. Household groceries, daily transport, your kids’ education - you name it, and that particular product or service costs far more than it did, say, four years back. In fact, there was a period, from May 2013 to September 2013, when the rupee fell drastically, from 54 to a dollar to 68. It doesn’t help that the rupee has depreciated down to 70 to a dollar now. So, we’ve been facing an uphill task for some time now.

Apart from day to day expenses, we all have some major investments we make - our long-term financial goals we commit to, in order to secure our future. For instance, most people wish to purchase a house or two or three depending on income. Because these can become regular sources of income in the form of rent, besides the appreciation in value of that property. Others prefer to purchase a four wheeler so they can make their daily commute easier, or because it has been a motivation for success and serves as a symbol of having arrived.

For such expenses, it is generally advisable to take the help of loans instead of making the purchase with your savings.

Okay, the word loan makes some of us nervous. We dislike the idea of a large debt on our heads. In fact, some of us see it as the opposite of financial freedom. So why are we discussing loans?

A loan can be taken to fulfil any life goal or finance an immediate requirement. Like that house, or that car you’ve always worked towards. Of course, a loan is also an added expense, considering the interest which banks levy on the EMI, or equated monthly instalment that you pay. Higher rates of interest can make repaying a more expensive proposition. The higher the rate of interest, the higher the EMI amount you hand over to the bank.

Let us examine a few methods that can help save money on the EMI we pay each month. Whether negotiating with the lending institution or changing your lender, we look at some solutions that can reduce the cost of your loan, and leave you with enough of your own wealth to live a quality life.

We know how we generally work with EMIs. When it comes to EMIs, we tend to look only at the amount which we can pay on a monthly basis, and budget accordingly. But as the tenure, i.e. the period over which such payments are to be made, increases, we end up paying quite a bit more in the form of interest.

Let’s illustrate with the help of the most common example in such a scenario - a home loan.

Getting your own house is an exciting dream that most of us hope for. Funding this new home can be a nightmare if we don’t plan our finances well. It is common knowledge that most home buyers use home loans to make such a purchase. That said, one still needs enough money for a heavy down payment. Then there is the EMI which eats away a large chunk from monthly salaries.

Before you get a loan, consider two things. First, try taking loans from your existing bank.

This could work in your favour if you have a good standing with your bank. The bank is more likely to provide a lower rate of interest on your preferred loan, which is point number two. Negotiate with your bank for a lower rate of interest on the loan. Banks are sometimes willing to do so for existing customers in order to increase brand loyalty, and also to attract more customers. Since interest rates are directly proportional to the amount of EMI, a lower rate of interest will mean that your EMI will also be low. To find the best deal in the market, you will have to compare the various rates offered by banks and non-banking financing companies or  NBFCs. Then, choose the one that best fits the bill. If your existing bank does not offer the best deal, feel free to explore. There is no shortage of credible loan providers in the market really. That said, make sure you read the finer details, the minutiae, of the loan - prepayment penalties, loan processing fees or other such charges which can raise the overall cost of the loan. Keep an eye out for what your current lender may be charged for the transfer of the loan.

Banks offer home loans on both fixed as well as floating rates. Wait, what are fixed rates and floating rates? A fixed rate of interest means the EMIs remain constant over the tenure of the loan. For floating interest rates, EMIs can fluctuate according to market dynamics, meaning interest rates can increase or decrease. MCLR, or marginal cost of funds based lending rate, which was introduced in April 2016, was first hiked in March. Currently, floating rate home loans are cheaper than fixed-rate loans. Suresh Sadagopan, founder, Ladder7 Financial Advisory, says “Don’t move to a fixed rate home loan yet. They are still 50-100 bps higher than the floating rate ones.” He advises new borrowers to opt for a floating rate loan, instead of a fixed rate one.

The amount you pay as EMI depends on the amount you borrowed. This, in turn, is based on how much you are eligible to borrow, as per the financier. We see a lot more double income households these days, so there is a good chance you and your spouse will be eligible for a large enough loan. But it is also important to keep in mind that eligibility for a large loan doesn’t mean that we should necessarily take that big a loan. The total take-home of the salaries is what your bank takes into consideration when deciding how much you are eligible for. Banks don’t really care how much you save. So, it is crucial that one keeps this in mind when seeking a loan. You ideally want an amount that you can comfortably repay. Because what’s the point of a nice house if you can’t afford an air-conditioner during a particularly hot summer?

What does one do in such a scenario?

Firstly, ensure you save up as much as you can before you avail a loan. That’s common sense, really, and a golden rule. You can then make a large down payment, thereby reducing the amount you need to borrow. The interest of a loan is calculated based on the principal amount borrowed by the customer. The higher the loan amount, the more money you will have to pay as interest and the higher your EMI amount will be. Therefore, it is a wise decision to pay a large amount as down payment. This will not only help you reduce the EMI of your loan, but also help you save big in the long run.

If you have tried that and still feel the EMIs are too big for your comfort, try to find a house a little below your ideal home but within your budget. This will probably require you to be pragmatic. Those months when you want to splurge on a big spend- say, a summer vacation with the wife and kids in South Africa - but you cannot because the responsibility of the EMI hangs over your head, just remember that your income is going towards an asset which has a good chance of appreciating, and not on an expense that will not add as much financial value to your net worth in the long run.

One efficient way of keeping a close eye on expenses is to allocate a separate account for servicing the loan. This is separate from your savings. It’s simple logic, really: when you have too many debits in the same account, they become difficult to track. If both you and your spouse are earning, it is important that you discuss where the debits will be made from. For instance, one of you can take care of the household expenses while the other looks after lifestyle expenses. Different accounts for different expenses tend to make it easier to control expenses and bring more discipline. You can also figure out what your spending patterns are.

Then comes the fundamental rule that all of this savings business hinges on: you can save only if you spend less. Rainy day and all that…

We all have unexpected expenses that throw our plans out of gear once in a while. Like an unexpected accident, surgery or a corpus fund that your building association has decided to levy. In such cases, you require a backup or a contingency fund. If we don’t maintain such emergency funds and fail to pay our EMIs, we run the risk of being marked defaulters. And that affects our credit scores. Rule of thumb here: a contingency fund should be able to service your EMIs for three months. You can start building such an emergency fund from the time you first get your home loan.

Conversely, you may have a windfall or two over time, an unexpected lump sum amount that falls in your lap. Maybe a large bonus or some such lucky strike. Use this amount to part prepay your loan. Avoid the temptation to splurge it on luxuries. If you decide to partially prepay your loan, you can choose to either bring down the EMI amount or reduce the overall tenure of the loan.

Amol Joshi, Founder, PlanRupee Investment Services, told the  Economic Times, “In the initial years, the interest component is higher and provides tax benefits, so prepaying after five-seven years works well.” This is especially true if you are younger, with fewer liabilities. Balakrishnan Venkataramani, Proprietor, Vensiva Financial Solutions, says, “In today’s uncertain job market, managing a fixed expense like an EMI, especially when it is high, can be a big challenge.”

Of course, you must be comfortable with the monthly cash flow that you have after reducing the EMI. If you find that you are not comfortable with this amount, you can cut down the EMI until your cash flow improves. It is useful in such a situation to bring down the overall tenure of the loan so that the total interest outflow reduces.

Then comes an important piece of advice. There are certain banks which offer you a step-down EMI option as well. In such a scheme, when a borrower gets a loan, he or she has to pay a larger amount as EMI during the start of the tenure. Over time, the EMI amount gradually decreases as the principal amount decreases after each monthly payment. Such a plan can help reduce the interest burden during the later part of the loan tenure. A step-down EMI is best suited for people closer to retirement because it is based on the cash flow needs of the customer. The EMI can be reduced temporarily and can be increased, once income and cash flow stabilise, using a step-up EMI option.

You can also consider refinancing your home loan. Refinancing a home loan means availing a new loan from another lender to pay off an existing loan. This provides two benefits: a lower rate of interest; and a top-up on the original loan amount. However, refinancing home loans can prove tricky to negotiate because the loan prepayment fee and other service charges levied by the lender can amount to a higher figure. This, in turn, results in reduced interest savings. But refinancing can also lead to lower EMIs. For example, if the interest rate falls from 10 percent per annum to 9 percent on a Rs 50 lakh home loan, the EMI drops from Rs ~45,000 to Rs ~42,000 and the overall savings on interest could work out to Rs ~10.4 lakh rupees over 25 years. This is just a rough estimate.

Finally, prioritize payment of loans with the highest interest rate. Some loans, like credit card loans, attract rather high rates of interest. If you have taken a credit card loan, a personal loan and a home loan, it is advisable to pay off the credit card loan ASAP. But what about the other loans? Well, while paying off the credit card loan, you can pay the minimum amount towards the repayment of your other loans. Hopefully, you don’t have too many other loans. By repaying the loan with the highest interest first, you can save on the high rate of interest which you otherwise would continue paying for a longer duration. If you are really keen on paying off the loan quickly, you can increase your EMI by a small percentage in order to save interest. This increase in percentage is usually based on the increase in your net income each year.