What You Need to Know About Home Financing

What You Need to Know About Home Financing

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Home financing is actually simple math that everybody learned when they were in school, but never applied it in this way. It is one of the unique financial products that results in a win win situation for the lender as well as the borrower, provided the borrower is aware of his or her limitations.

Buying a home is never an easy thing, because of the costs, which include costs towards registration, legal verification, inspection, brokerage, etc. Without availing home finance, few would be in a position to purchase the home that meets many of their requirements.

Variations based on the way interest is calculated

Options include:

a. fixed rate home loans

b. adjustable rate home loans

c. interest only home loans

In fixed rate bearing home financing, the interest rate does not vary throughout the loan term. Unlike fixed rate home financing however, in adjustable rate home financing, interest rates vary according to the agreed index.

In interest only home loans, the lender agrees to accept only the interest at regular intervals, till the end of loan term, when the borrower becomes liable to repay the entire loan. There can be permutations and combinations of these varieties of loans.

Understanding EMIs

Usually, home loans are repaid in equated monthly installments, which are better known as EMIs. These EMIs are made of two bits of which one is the interest component, and the other is the principle component. The principle component keeps increasing each month, and the interest component keeps decreasing every month.

Note that the interest component is interest for the year calculated at the agreed rate on the outstanding loan amount, which is then divided by 12 to get the monthly interest component. It varies from month to month, because each month the principle is reduced slightly, and therefore, the interest component in the following month would be down too.

EMIs vis-a-vis interest calculation

In fixed rate home loans, neither the EMI nor the term vary. But in adjustable rate home loans, EMIs may increase, or the term may be extended.

In interest only home loans, the EMIs are essentially and only the interest component, though very few lenders would offer such loans.

Interest only home loans may again have fixed interest bearing interest only home loans, and adjustable interest bearing interest only home loans. In the latter category, the EMIs may vary.

Choice in term and risks

The term of the home loan can be chosen by the borrower. Choices include 2 years, 5 years, 10 years, 15 years, 20 years, and even 30 or 35 year home loans. Much depends upon the prevailing interest rates, economic conditions, age of the borrower, employment details of the borrower, etc.

Obviously, the interest that the borrower pays to the lender in the short term would be less. As far as the lenders are concerned, it reduces their risks so they are more amenable to offer lower interest rates on home loans of shorter duration.

But there is an inherent risk in availing shorter term home financing. If, for any reason, the borrower is unable to repay the loan in time, then the risk of foreclosure looms large.

Home loans for contractors

While so, some lenders are inclined to take risks and offer shorter term loans at higher interest rates to certain category of home loan seekers such as freelancers and contractors. This category of borrowers are often at a great disadvantage because there are few lenders willing to offer home loans to them.

The worst possible home loan finance available to such borrowers is by calculating simple interest for the entire home loan term and adding it back to the principle the borrower seeks, and dividing this amount across the number of months in the agreed term.

This is quite like the hire purchase financing type of loans, but in the absence of home loans, some borrowers who do not understand the implications may end up borrowing in this way. In this type of home home loan finance, the borrower ends up paying interest even on the principle he or she has repaid. Some unscrupulous lenders may go so far as deducting the first installment and other charges upfront from the agreed loan amount. This increases the overall interest rate on the home loan. The borrower needs to be wary of borrowing from such lenders.

Conclusion

What needs to be understood about home loan financing is that, the longer the term, the longer would be the duration before the principle starts reducing rapidly within the EMIs.

Effectively, the borrower would be paying more interest to the lender. However, the amount paid as interest to the lender should not scare the borrower because it needs to be discounted at the inflation rate for each of those years within the term, to arrive at the amount that actually leaves the borrower’s pockets.

Corresponding reduction in EMIs may not be significant. The borrower needs to thoroughly examine his or her present and future cash flows and incorporate some contingency plan if using shorter term home loans to avoid the risk of foreclosure.

Likewise, the borrower needs to be realistic about what he or she can afford to buy. If you could share this information on home financing with your friends on social websites like facebook, then a few more prospective home buyers would become more aware of their home loan options and how they should avail of such loans, and of course, the risks.

Image credit: Home Loan, on Flickr

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