By Sunil Parameswaran
It used to be normal practice to save money and buy a house right before retirement or upon retirement. In fact, most people would use their contingency funds to buy a home. Government workers would use that money to buy a house, and then rely on their retirement income for other expenses. Those who were supported by adult children had another source of support.
Today, people in their early twenties take out home loans. A mortgage is an amortized loan. That is, it is repaid in the form of equal installments, usually monthly. Hence the word EMI. The present value of all IMEs is the loan amount. Each EMI consists of a partial payment of principal and interest on the outstanding balance. Since the outstanding balance decreases steadily, the interest component of the EMI will decrease steadily, while the principal component will increase steadily.
The sum of the two, which is the IME, will remain constant. So, if a person were to take out a 15-year loan, in the early years the EMI will mostly consist of an interest payment. Towards the end of the loan, the EMI will consist mainly of repayment of the principal. It might sound like a lot of sense, but lenders in the United States have learned a lesson the hard way. About 75 years ago, the practice was to give loans over 360 months or 30 years, with the first 359 payments being interest only and full principal repayment at the end of the loan. Needless to say there were major flaws. Then someone thought that they had to come up with a method to get the principal back in installments from the start, and the result was the creation of amortized loans.
The property acquired is the security for the loan. Unlike India, where real estate prices generally rise steadily, in Western countries it is an asset whose prices fluctuate with economic conditions just like stock prices. So, to acquire a property with a price of “X” dollars, the borrower cannot get 100% financing.
They will need to make a down payment or margin payment, and the balance can be borrowed. The ratio of the amount borrowed to the market value of the home is called the Loan to Value or LTV ratio. The lower the ratio, the greater the margin of safety for the lender. Lenders also look at what is known as the “payment to income” or PTI ratio. It is the ratio of the monthly payments due to the monthly income of the borrower. The lower the PTI ratio, the more reassured the lender is.
The monthly payment for a borrower is not just the EMI. Borrowers should get their property insured to protect against unforeseen events. In addition, property taxes must be paid annually. In practice, lenders require borrowers to contribute to an escrow account. Once done, it is the lender’s responsibility to make statutory payments on time. Property insurance is required by most lenders.
Borrowers will also be concerned about the specter of family members having to leave the property, in the event of a calamity. It is possible to acquire an insurance policy that will allow family members to continue making EMI payments even if something should happen to the borrower. In the United States, this is called credit life insurance.
The author is CEO of Tarheel Consultancy Services