Stepping stones

A step-up loan might help you buy that dream home

It's a dilemma that many homebuyers face. They've seen a house that's just right but the repayments are slightly too high. Should they settle for a smaller house that isn't so nice or should they overstretch their budget?

For some mortage hunters there's a new answer. Banks are now coming to the conclusion that some select customers can be given bigger loans and the flexible option of staggering payments in such a way monthly payments are lower in the early years.

The banks call these step up loans and they are now available from ICICI Bank and Housing Development Finance Corporation (HDFC).

Public sector banks like Union Bank of India offer a slightly modified version of the scheme "" customers won't be given bigger loans but they can make lower payments for the first few years on their loans.

Other banks like UTI Bank are still working out how their schemes will work. "It has twin advantages of a higher eligibility and a repayment structure that will increase when the salary of the individual increases," says Rajiv Sabharwal, COO - home loans, ICICI Bank.

So what exactly is a step up home loan? A step up loan is a home loan that a bank gives an individual based on the assumption that his/her salary will increase a certain percentage annually.

Under a step-up loan people can take a higher loan than they might have been entitled to. Also, the structured re-payment facility allows the consumer to decide whether he wants to pay a higher EMI in the first half of the loan tenure or in the second half.

A step up loan is a home loan that a bank gives a person based on the assumption that his salary will increase a certain percentage annually

Currently ICICI Bank and HDFC are offering step up loans

ICICI Bank's offers a floating rate product and the interest rate for a 15 year and 20 year loan tenure is 7.5 per cent

HDFC offers a fixed rate product and the interest rate is 7.5 per cent for a loan of above Rs 25 lakh

This is different from a top-up loan which is over and above the existing loan you may have taken from a bank.

For instance, a top-up loan is when a person takes a Rs 10 lakh loan ten years ago and takes another Rs 5 lakh now.

The way a step-up loan works is slightly different. Suppose you are eligible for a Rs 17 lakh normal home loan today. Under the step-up loan, the bank assumes that your salary will increase 20 per cent annually. Using that calculation they may decide that you are eligible for a home loan of, perhaps, Rs 22 lakh to start with.

How does this work? Both HDFC and ICICI Bank take a call on the individual's income and based on his/her past background, educational qualifications and other factors, decide how much the salary package might increase each year.

If, for instance, you are an engineer working in the middle management of a fairly well known manufacturing company, the banks will take a view that your salary is likely to increase anywhere between 5 per cent to 7 per cent annually. The loan eligibility will be computed on the basis of that increase rather than your existing salary.

Clearly, a person with better job prospects and educational qualifications is more likely to be considered for such a loan.

In the case of ICICI Bank, the loan eligibility could be as much as 30 per cent depending on the individual, while HDFC averages a 5 per cent to 12 per cent higher eligibility.

ICICI Bank's product is a floating rate product and currently the interest rate for a 15 year and 20 year loan tenure is 7.5 per cent which is comparable to normal home loan schemes.

HDFC's product on the other hand is a fixed rate product with the interest rate being 7.5 per cent on a loan amount above Rs 25 lakh and 7.75 per cent on a loan amount ranging from Rs 10 lakh to Rs 25 lakh.

The repayment structures differ. Typically the loan tenure will be divided into three phases "" 1-2 years, 3-10 years (or 3-7 years) and 11-20 years (or 8-20 years).

HDFC allows the customer the flexibility to choose whether he wants to pay a higher EMI in the first phase, middle phase or last phase.

ICICI Bank, however, offers the customer the option of paying the lowest equated monthly instalment (EMI) (which only includes the interest component) in the first two years. Suppose, you have taken a loan at 7.5 per cent for 20 years for Rs 10 lakh.

In year one and two, your EMI per lakh will be Rs 625. From the third year to the seventh year, you will pay Rs 806 per lakh and from the eighth year onwards, Rs 874. Compared to this, for a normal loan you will pay Rs 806 per lakh throughout the tenure of the loan.

But there is a catch. In the ICICI bank loan, for instance, if interest rates go up in the first two years, because the EMI only has the interest component and doesn't include a re-payment on the principal, the gross interest will go up.

So if you have taken a loan of Rs 10 lakh and are paying Rs 625 per lakh at the rate of 7.5 per cent and the interest rate goes up by 0.25 per cent, your EMI will go up to Rs 645 per lakh. The Rs 20 per lakh difference will get added to your principal. Since all payements are made by post dated cheques, the tenure of the loan will go up.

Clearly, this is not a product for everybody. In fact, HDFC doesn't offer it to all its customers. Only people who can expect regular salary increases will be offered this product.

Says Suresh Menon, general manager - Mumbai region, HDFC, "The chances of further growth have to be higher than the rate of inflation. It was introduced to attract a younger set of customers."

ICICI Bank's Sabharwal says that this product suits younger customers who may be first-time or second-time home buyers and also people who are looking at maximising tax benefits later in life when their salaries will be very high.

If you are among those who are eligible for this product, consider it. It will, after all, mean acquiring that two-bedroom house today rather than ten years later. But don't forget to understand the product and read the fine print.