There is no standard nomenclature. The nomenclature may differ across banks.
I call these step-up home loans because EMI increases after a few years. Let’ dig deeper.
What are Step-up home loan products?
Under such loans, there are two types of repayment periods.
- Moratorium period (let’s call it that): It can be 3-5 years depending upon the loan product. During this period, you have moratorium on principal repayments (and not on interest payment) i.e. you pay only the interest amount during this period.
- Regular repayment period (couldn’t think of better names): You pay the full EMI during the period i.e. you pay both principal and interest during this period.
If the loan tenure is 20 years and moratorium period is 5 years, regular repayment period will be 15 years.
Please understand these products are not standard and may have different structures. In this post, I will focus on the underlying across such products i.e. the increase in loan eligibility.
How is the Loan Eligibility under such loans higher?
When bank gives you a loan, it tries to assess your repayment ability.
Typically, banks don’t want to lend more than you can afford to repay. For this, banks calculate Fixed Income to Obligations Ratio (FIOR). As the name suggests, it measures the percentage of your income that goes towards loan EMIs (after including the loan under question).
Banks may have different thresholds. For instance, a particular bank may not be comfortable if FIOR exceeds say 40%.
By the way, the bank may look at other aspects too such as your relationship with banks, your credit score and your repayment history (CIBIL report).
Read: How to download your free CIBIL report?
Let’s see how a step-up loan can affect your loan eligibility
Under a reducing balance loan, a portion of your every EMI goes towards interest payment while the remaining is used to repay the principal amount.
Let’s assume you earn Rs 60,000 per month and the bank you have applied to is comfortable with FIOR of 40%. Assuming you have no other loans, the maximum EMI that you can afford is Rs 24,000.
Therefore, the bank will not sanction the loan amount for which EMI will exceed Rs 24,000.
Suppose you are going for a 20 year loan.
At an interest rate of 9%, loan tenor of 20 years and EMI of Rs 24,000, the maximum loan amount will be Rs 26.67 lacs.
What if you need loan for a bigger amount? After all, you need to purchase your dream house.
There are three ways:
- You can manage more from own funds, doing away with the need for a higher loan amount.
- You can increase the loan tenure. Loan EMI will go down with loan tenure, effectively increasing your eligibility.
- You can shop for a lower interest rate. A lower rate will also increase your loan eligibility. For instance, at interest rate of 8%, your loan eligibility will be Rs 28.7 lacs.
What if you don’t have such options at your disposal?
What if you can’t manage more funds from own money or the bank is unwilling to increase the loan tenure or you have already hit the tenure ceiling?
The interest rates are anyways beyond your control. You can get a slightly better rate but that won’t make meaningful difference to loan eligibility.
This is where step-up loans can help.
Since during the moratorium period, you are paying only the interest, your loan eligibility can be higher.
Let’s see how.
From the perspective of the bank, since you have to pay only interest during the moratorium period, your loan eligibility can be much higher.
At EMI of Rs 24,000 (interest only), loan tenure of 20 years and interest of 9% p.a., the maximum loan amount can be Rs 32 lacs (Rs 24,000(8%/12)).
Therefore, your home loan eligibility has gone up from Rs 26.67 lacs to Rs 32 lacs (i.e. by almost 20%).
What are the risks?
Clearly, both you and the bank believe that you will be able to increase your income by the time moratorium period gets over.
If that does not happen, you will be in serious trouble.
For instance, in this case, you go for a step-up loan of Rs 32 lacs. During moratorium period, the EMI will be Rs 24,000. Once the moratorium period is over, EMI will jump from Rs 24,000 to Rs 32,456 once the moratorium period gets over. An increase of over 35%.
You should be able to afford higher EMI.
If you had taken a regular home loan for the same amount (Rs 32 lacs), you would have to pay an EMI of Rs 28,791.
As compared to a regular home loan, you pay lower EMI during the moratorium period and a higher EMI for the remaining years.
You pay more interest too
Continuing with the same example (Rs 32 lacs, 9%, 20 years), you pay total interest of ~37.02 lacs under regular home loan product.
On the other hand, you pay total interest of Rs 40.8 lacs under step-up home loan option.
You pay more interest. This is because you didn’t pay any principal during the first 3-5 years (moratorium period) in the step-up loan method.
I have assumed interest rate will remain constant during the course of the loan.
Do note only the amount of absolute interest is higher. The cost of loan is still the same (before considering any tax benefits).
What are the eligibility conditions?
I had a look at two such products. SBI FlexiPay Home Loan Scheme and ICICI Step-Up Home loan.
If you go through the eligibility conditions, you will find that such products are not available to everyone.
For instance,
- Both the products were available to only salaried employees. ICICI Step-up home loan product was available to only employees of select corporates.
- Not available to self-employed.
- A minimum and maximum age criterion was there.
- SBI Flexipay Home Loan Scheme mandates minimum two years of work experience.
These loans are different from Pre-EMI
Even regular home loan have this option to choose Pre-EMI.
With the concept of Pre-EMI, you can choose to pay only the interest on the disbursed amount till such time construction of your house is complete. Once the construction of the house is complete or the entire loan has been disbursed, you have to pay the full EMI.
For more on Pre-EMI and Full-EMI, refer to this post on EMICalculator.
The intent is to reduce the burden on your cash flows because paying rent and the home loan EMI at the same time may trouble many home buyers. Once the construction of the house is complete, you can move into the house and avoid paying rent. For greater details, refer to the aforementioned post on EMICalculator.
Step-up loans are different from Pre-EMI concept under regular home loans.
- Step-up loans are also available for constructed properties/resale market. Pre-EMI facility is available for under-construction properties.
- With Pre-EMI, banks do not consider you for higher loan eligibility. And it is quite logical too. What if the developer delivers the house in the next 1 year and your income is still not enough to support higher EMI payments?
What should you do?
There is no reason for go for step-up loans unless you need a higher loan eligibility. No point paying only interest for so many years if you can afford to pay the full EMI.
If you need loan for the higher amount, you can consider such products.
However, you need to be sure about your career prospects and moves. If the income does not grow as anticipated, you will face problems.
Banks are not too much bothered. They have your house as the security. If you can’t pay the loan, they can sell the house.
As with any kind of debt, do not borrow more than you can repay.
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