A friend asked, “What should be the tenure of a home loan?”
I answered, “Depends on the affordability.”
My friend replied, “Affordability is always subjective. In my opinion, go for longer tenure. This way EMI will be low. You can save more. And use the saved amount to prepay the loan. This will automatically reduce the tenure”.
It seemed counter-intuitive to me. He wanted to go longer tenure so that he could repay the loan early. To be honest, his approach didn’t appeal much to me. Well, if you are so sure that you can save more, why not start with a shorter tenure and a higher EMI in the first place. I left it at that.
However, when I reconsidered his suggestion while talking to a client, I realized he had a valid point.
Let’s first see how home loan tenure affects you as a borrower.
How long tenure affects you?
Longer the tenure, the more you pay in terms of absolute interest.
Longer tenure means lower EMI and a higher interest outgo.
For instance, EMI for Rs 50 lacs loan at 10% p.a. for a tenure of 15 years will be Rs. 53,730. EMI for a 20 year loan will be Rs 48,251.
Under the 15 year loan, total interest paid is Rs 46.71 lacs while in case of 20 year loan, total interest paid is Rs 65.8 lacs.
No surprise bank will want you to stay longer in the loan.
Do note that the cost of loan is 10% p.a. in both the cases. The difference is only in absolute interest amount.
Longer Tenure can increase our home loan eligibility
Longer tenure is not always bad.
Banks have internal policies to ensure that your loan EMIs does not exceed a certain percentage of your monthly income (say, 40-45%).
With monthly income of Rs 1 lacs and bank’s fixed obligation to income ratio of 40%, you will be considered for a maximum EMI of Rs 40,000.
At 10% p.a. and loan EMI of Rs 40,000, you will be eligible for a loan of Rs 37 lacs if you opt for loan tenure of 15 years. For a loan tenure of 25 years, your loan eligibility goes up to Rs. 44 lacs.
Hence, increase in loan tenure is a way to increase your loan liability.
Hence, many a times, when you are looking for a higher loan amount, your hand may be forced. You may have to go for a longer duration.
There is a drawback too with longer tenure. When the interest rates goes up, banks typically increase the loan tenure and keep the EMI same. However, if your loan tenure is already stretched and the bank cannot increase the tenure further, the bank will have to increase the EMI. This can be a problem if you cash flows are stretched.
What should be the ideal home loan tenure?
In my opinion, you should not focus too much on home loan tenure. Focus on the following aspects. Tenure will automatically fall in place.
1. Consider affordability of EMI
If the EMI for shorter loan tenure is not affordable, then shorter tenure is simply not an option.
Go for the tenure that makes the EMI affordable.
In fact, banks give good weight to this aspect. A bank may not be comfortable offering a loan with EMI greater than 40-45% of monthly income (Fixed obligations to income ratio). By the way, the bank will consider your other running loans too.
In my opinion, your loan EMIs should not exceed 40-45% (will vary from case to case) of the take home pay. If it does, your ability to invest for other financial goals is likely to get severely compromised.
If affordability is not a problem and higher EMI does not affect your ability to invest for other goals, then it is your choice.
Personally, I would go for a shorter tenure.
2. Use annual bonuses or any windfall to prepay loan
If you plan to prepay your loan (much before original tenure), use annual bonuses or gifts or any matured investment to prepay the loan.
3. Your age is important
You wouldn’t want to have a loan outstanding when you retire. Hence, if you are 40, don’t go for tenure greater than 20 years (assuming you retire at 60). Banks will take care of this aspect.
4. Tax Benefits
Personally, I wouldn’t give too much weight to this aspect. In my post on hype surrounding tax benefits for home loans, I have discussed this aspect in detail in the aforementioned post.
About the ideal tenure, there is no right or wrong answer. Choose an EMI you are comfortable with. Make sure that your other goals do not get compromised because of home loan commitment.
In my opinion, when in doubt about repayment ability, go for a longer tenure. Even if you have started with longer tenure, you can use salary hikes and any cash windfalls to prepay your home loan and reduce loan tenure. So, my friend actually made a lot of sense.