The interest rate factor

It was a small blow for would be homebuyers. After almost three years of steadily moving downwards interest rates are turning around.

The first move came last week when HDFC, the home finance giant raised fixed rate home loans by 0.75 per cent. Since HDFC is an industry leader it's fairly sure that others will follow suit soon.

There are other signals that investors should be keeping an eye on. Take a look, for instance, at the 10-year government securities market where rates have risen above 6 per cent compared to under 5.80 per cent a year ago.

What all this means is clear enough "" interest rates are about to rise. And that affects both borrowings and savings. The downside is that taking a loan from a bank will become more expensive. The upside is that returns on fixed deposits will also rise.

Should investors be re-jigging their investment strategies in these new circumstances? Says Nimish Shah, chief executive officer and director at Parag Parikh Financial Advisory Services, "Investors should look at short term or medium term investing strategies."

To start with, investors looking for a home loan, should lock it in as soon as possible into a fixed rate product. But they should read the fine print carefully before making any choices. Firstly, not many banks offer fixed rate loans.

For instance, HSBC offers a fixed rate product for only three years. And that's not all. Many banks offer products that aren't really fixed rate contracts "" the fine print will contain a clause that rates will rise if there are adverse conditions in the money market.

Take HDFC for instance. It now offers customers two options in its fixed rate products. One option allows HDFC to increase the rate given extreme volatility in the money markets and is pegged 25 basis points lower than the other option.

The other option has higher interest rates but these remain fixed for the entire tenure of the loan.

Homebuyers must, of course, first decide whether they want to take a fixed rate loan or whether they are willing to take a risk that interest rates will head downwards eventually.

Currently the differential between fixed rates and floating rates is about 75 basis points, so it really depends on how much a person thinks interest rates will increase in the long term.

"The ideal condition is to look at a mixed product where 50 per cent of the loan is a fixed rate product and the remaining is a floating rate product so you're covered to the extent of extremely adverse interest rate changes," says a financial advisor.

While other banks and home finance companies are yet to follow suit, gradual interest rate increases are expected to take place within a month or two. So if you have chosen a property, this is the time to figure out that loan. And if it's possible to find a bank that will finance a home loan at a fixed rate for at least the medium or long term, then pick it up.

Shifting to a fixed rate, however, is something an investor has to consider keeping in mind the penalties a loan balance transfer will entail. Loan balance transfer is the penalty you pay for transferring your loan from a fixed rate to a floating rate and vice-versa. The penalty is generally 2 per cent.

On the saving front also it might be time to re-look at investments. One possibility is shifting from debt funds to fixed deposits. The one year annualised return on medium term debt funds (growth and dividend) on a dividend adjusted basis in 2003-2004 fell to 5.42 per cent compared to 8.71 per cent in 2002-03.

The reason, financial planners recommend a shift is because debt funds invest in bonds, the prices of which depend on interest rates, among other things. If interest rates rise, bond prices fall, therefore impacting debt funds that invest in them.

The safer option is to invest in bank fixed deposits. Says Ambareesh Baliga, vice president, Karvy Stock Broking, "Investing in fixed deposits for 90 to 180 days makes sense because of the interest rates that banks are offering."

So like State Bank of India's fixed deposits for 46-179 days bear a 4.50 per cent interest rate while putting money in the 180 to less than a year deposit will come with a 4.75 per cent interest earning.

Similarly, ICICI Bank offers a 4.5 per cent rate on fixed deposits under Rs 15 lakh for a period of 91-180 days. Co-operative banks offer slightly higher rates at about 6 per cent provided you are willing to take the risk of investing in them.

"On the whole, one needs to be comfortable with the lock-ins as far as these deposits are concerned and the fact that the income earned is taxable," says a Mumbai-based tax consultant.

Within debt funds, however, there is the option of looking at floating rate funds or liquid funds with short term maturities. The difference in these is that their choice of investible instruments makes them more immune to interest rate changes, says another planner.

And of course, there are the small savings schemes which offer both high returns, security and tax benefits. "Investors should take full advantage of the public provident funds, Kisan Vikas Patra and other small savings schemes," says Parag Parikh's Shah.

The only drawback is the lock-in period of 15 years or in some cases of three to five years, so Shah says these investments should be done keeping in mind a longer term perspective. And there are also RBI Bonds which still offer 8.5 per cent taxable returns.

For people willing to take a reasonable level of risk, Baliga and Shah also advise looking at dividend yield stocks. "For people who are willing to take the risk, putting 5 per cent of their portfolio into dividend yield stocks makes sense," says Baliga.

Essentially dividend yield stocks deliver regular dividends that match the returns that can be had from debt instruments. Stocks that yield a high dividend in comparison to the share price are the ones to look out for.

The lure is the high possibility of periodic returns (a decision based on the past history of the company) and the potential for capital appreciation if the market does well.