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Paying EMIs on time, but still a defaulter!

Amar Pandit | August 18, 2008 12:16 IST

When home prices are going up, your equity in your home also goes up. Let's understand this with an example. Consider, three years back you bought a property for Rs 50 lakh (Rs 5 million), with Rs 500,000 as down payment and a home loan of Rs 45 lakh (Rs 4.5 million). Now, if the property is priced at Rs 1 crore (Rs 10 million), it means that even if you were to sell it off and repay the entire home loan, you would still make around Rs 55 lakh (Rs 5.5 million) as net profit.

The other advantage is the rise in the price would also make you eligible for an additional loan against the property. Known as the concept of home equity, this is quite a common product in the US. In India, most banks call it as a top-up loan, where borrowers can garner further amounts, based on the existing valuation of the property.

While the rise in property prices leads to an increase in home equity, the reverse is also true. That is, when prices of property fall, your home equity diminishes. In recent times, there have been reports of real estate prices cooling off. A reality check also establishes that very few transactions are happening today. This could lead to some price corrections, and quite sharply, in areas where prices have risen too fast, too soon.

This could be music to the ears of the potential home buyers. But for the existing home owners, the situation could get a little tricky. Falling property price would mean that their home equity would be going southwards as well. Though many are not aware, there is a clause in the home loan contract, hidden among many other clauses, called the "Depreciation of Security" clause.

Let us understand the importance of the clause with this example. For instance, the same house worth Rs 50 lakh is bought by a personal contribution of Rs 500,000 and a home loan of Rs 45 lakh for 15 years. If the real estate market corrects by say, 25 per cent in the third year, the value of the property goes down to Rs 37.5 lakh (Rs 3.75 million). However, the bank has lent you Rs 45 lakh.

If such a situation arises, the bank reserves the prerogative to ask for more security to keep their exposure restricted to 90 per cent of the property value. In this case, the bank's ideal exposure should be to the tune of Rs 33.75 lakh (Rs 3.37 million).

This automatically gives the bank the right to ask for the difference that would be over Rs 10 lakh (since in the earlier years of the home loan, only the interest payout happens; the principal only starts in the later years). And if you are unable to do so, it implies that you are a defaulter, even though you are paying equated monthly instalments on time.

In the rush to own that dream home, such key points are overlooked. Often, even household budgets are overstretched for this purpose. But it is important to remember that buying a residential property on loan means you are leveraging on the bank's money.

Buyers, who have entered the market at lower levels and have not topped up their loans, can breathe a sigh of relief. On the other hand, those who have bought in recent years could find themselves in a tight spot, if prices were to go down too sharply.

The most common worry among home buyers is the rise in interest rates that leads to a hike in EMIs. The bigger risk, however, is the inability to pay upfront funds, when the bank asks for it. One should always be prepared for such eventualities. Remember that just because the EMIs are being paid on time does not give you immunity from default.

More importantly, if you are unable to fork out the additional amount, you will be immediately relegated to the defaulter's category. And that implies that your entire outstanding loan amount becomes payable immediately.

To avoid such circumstances, keep the following things in mind before taking a home loan:

  • Never overstretch your budget. If you want that extra bedroom that makes you overstretch your finances, think again.
  • Just because the bank is lending you 90-95 per cent, it does not mean you should be borrowing to the hilt. Instead opt for a safe 60-70 per cent funding because that is a good hedge against falling prices.
  • Always keep a buffer amount to counter any rise in EMIs.
  • Always pay a fair price for your house. Negotiate if you think the valuations are crazy. The best option is to wait if you can, especially in prevalent uncertain times.

The bottom line is borrowing prudently saves you a lot of trouble, especially in scenarios when things are on a downturn.

The writer is director, My Financial Advisor.

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