In August 2015, Arundhati Bhattacharya the Chairman of the State Bank of India (SBI), had suggested that the country’s largest bank be allowed to launch teaser rate home loans. As she had said back then: “In fact, the first suggestion that I made (was) that, for a limited period, home loans could be given at below base rate for the already heavy stock of housing.” Base rate is the minimum interest rate a bank charges to its customers.
The bank had first launched teaser rate home loans in 2009. These loans are essentially home loans in which the interest rate is fixed in the initial years and is lower than the normal floating interest rate on a home loan. The lower interest rate is limited only to the first two-three years, after which the loan is priced at the prevailing interest rate on the home loans. Hence, the EMIs for the borrower during the first few years are lower than they would have been in the normal scheme of things.
Yesterday (i.e. February 1, 2016), SBI went a step further, and launched a home loan in which the monthly payments initially will be even lower than the EMIs paid in case of teaser rate home loans. It launched what it calls the SBI FlexiPay Home Loan.
As the press release of the announcement of this home loan points out: “The new offering, ‘SBI FlexiPay Home Loan’, will enable young working professionals / executives to get higher loan amount compared to their loan eligibility under normal Home Loan schemes. The additional loan amount will help such professionals in acquiring better and spacious living spaces for themselves and their families, taking into account their future needs.”
Hence, anyone applying for a FlexiPay Home Loan will get a higher amount of home loan than his or her loan eligibility would permit under normal circumstances. And there is more to this as well. As the SBI press release points out: “Further, to lower the impact of such additional loan amount on monthly repayments in the form of EMIs, the customers availing Home Loan under ‘SBI FlexiPay Home Loan Scheme’ will also be offered the option of paying only interest during the moratorium (pre-EMI) period of 3 to 5 years, and thereafter, pay moderated EMIs. The EMIs will be stepped-up during the subsequent years.”
So, other than getting a higher loan amount, the loan also comes with the option of the borrower only paying the interest on the loan during the first few years. And this makes things very interesting.
As the SBI press release points out: “Soaring aspiration levels and rising awareness about the impact of quality living spaces on healthy and harmonious living are resulting in our newer generation of working professionals to show greater preference for better and larger homes. But they are constrained from purchasing their dream homes due to the relatively lower income available at early stage of their career.”
Hence, the FlexiPay home loan will essentially allow people buy a home which they otherwise wouldn’t have been able to afford given their current level of income. As SBI puts it, the loan tries to “to bridge the gap between affordability and demand for quality residential spaces in the country”.
There are multiple questions that arise here. Let me try and answer them one by one.
a) Why is SBI doing this? The answer lies in the numbers. The bank like other public sector banks has significantly lower bad loans when it lends to retail consumers than when it lends to corporates. As on September 30, 2015, the bad loans when it came to lending to retail sector (i.e. home loans, auto loans, personal loans etc.) were at 1.03% of the total lending carried out to the sector. This number had been at 1.37% as on September 30, 2014.
In comparison, the bad loans while lending to mid-level corporates were at 10.62%. Bad loans while lending to small and medium enterprises were at 8.72%. Also, while the overall bad loan rate in case of retail loans is 1.03%, it is safe to say that the bad loans rate while giving out home loans would be lower.
One explanation for this lies in the fact that it is easy to unleash legal proceedings (or the threat of) against retail borrowers and get them to pay up than it is to do against corporates. Hence, it makes sense for the bank to give out home loans in comparison to other loans, where recovery is difficult.
In fact, between September 2014 and September 2015, 25% of all domestic lending carried out by the bank was in the form of home loans.
b) Should SBI be doing this? It is clear that SBI wants to give out more home loans. The trouble with the FlexiPay home loan is that it relaxes the lending standards while giving out a home loan. As the press release points out that the loan will help the borrower “to get higher loan amount compared to their loan eligibility under normal Home Loan scheme”.
While this will allow the bank to lend more, relaxing lending standards in order to lend more is not always the best way to expand the loan book. As the SBI press release further says the loan will help “to bridge the gap between affordability and demand for quality residential spaces in the country”.
The function of any bank is to give loans and to give them out to those people and institutions who are likely to return it. It is not the function of a bank to improve the real estate scenario in a country by lowering its lending standards.
Further, in the interest only version of the loan the EMI is likely to jump up once the principal repayment (through the EMI) also kicks in after a period of three to five years. In fact, even after three to five years, when EMIs kick-in, the borrowers will have to “pay moderated EMIs”.
The bank is essentially working with the assumption that the income of the borrower will go up during the period and he will be in a position to pay the higher EMI. But is that likely to be the case?
Let’s try and understand this through an example. The scheme allows for upto 1.2 times higher loan eligibility compared to the loan eligibility under the normal home loan scheme. The loan amount has to be Rs 20 lakh or higher. What this means is that anyone with a loan eligibility of Rs 50 lakh under normal conditions, can take a loan of upto Rs 60 lakh.
Over and above this he can choose only to pay interest on it for the first five years. The current rate of interest on an SBI home loan is 9.55% (9.5% for women). Hence, the monthly payment for the first five years will come to Rs 47,750 (9.55% of Rs 60 lakh divided by 12).
The question is if the borrower chooses to pay this amount as an EMI what loan amount will he be eligible for? SBI offers a tenure of up to 30 years on its home loans. At an interest of 9.55% and a tenure of 30 years, an EMI of Rs 47,750, is good enough to repay a loan of Rs 56.55 lakh, which isn’t very different from Rs 60 lakh. (The EMI for a Rs 56.55 lakh home loan to be repaid over 30 years and at an interest of 9.55% comes to Rs 47,757).
The trouble is the eligibility of the borrower under the normal home loan is only Rs 50 lakh and he won’t get a loan of Rs 56.55 lakh. By structuring the loan the way it has, SBI gets to collect interest longer than it actually would have.
What happens once the EMI kicks in after five years? The bank talks about moderated EMIs. It does not define what it means by it. Assuming that principal repayment starts after five years, the EMI will jump to around Rs 52,630.5. This means that the borrower will repay the home loan over the next 25 years, making the total tenure of the loan repayment 30 years. The scheme allows for repayment period of 25 to 30 years.
If the repayment is made over the next 20 years, meaning a tenure of 25 years, the EMI jumps to Rs 56,124. The EMI does not increase significantly in comparison to the earlier monthly payment. The reason for this lies in the fact that SBI has limited the loan eligibility under this scheme to just 20% more than the normal home loan scheme. Hence, to that extent SBI is not making a very risky loan, even though it is taking on some more risk than it currently is.
Also, it is important to understand here that once SBI launches a product, other banks and housing finance companies will have follow. If they stick to 1.2 times the normal loan amount, they will not be giving out very risky loans. If they get aggressive and up the ante, that will mean the lowering of home loan lending standards throughout the system. Hence, the RBI will have to keep a watch on this.
c) What can we learn from the American experience? Interest only home loans were a big reason behind the home loan bubble in the United States between 2000 and 2007. In the American context they were referred to as the option adjustable-rate mortgage (ARM). An option ARM was a 30-year home loan in which the borrower had the option of paying a lower EMI initially. One version of the product was called 5/1 interest-only option ARM.
In this, the interest rate was reset after the first five years and then every year after that. Also, for the first five years, the borrower needed to pay back only interest on the home loan. In the American case, the interest rate in case of an interest only home loan was significantly lower than the normal home loan.
Hence, this product allowed borrowers to buy homes which were significantly more expensive than they could afford. In the Indian case, the interest on the interest only home loan is the same as the normal home loan.
Also, in the United States, after a point there was a race among banks and financial institutions to give out these loans. As more such loans were given, home prices went up, leading to a huge real estate bubble.
Once the higher EMIs started kicking in, the borrowers started defaulting on their loans. This eventually led to the start of the financial crisis that the world is currently battling. Given this, the lessons from the American experience are very clear. Interest only home loans are pretty risky if the interest rate differential between a normal home loan and an interest only home loan is high. That is clearly not the case with the new SBI FlexiPay home loan and this brings us back to the original question.
d) Why is the SBI doing this? From what the RBI governor Raghuram Rajan has been saying, it doesn’t seem that this home loan scheme would have had a total buy-in from him. Given this, I think SBI may have been nudged to launch this scheme by the finance ministry, in order to get the real estate sector going in this country. Given that I have no evidence for this, to that extent this remains a conspiracy theory.
Nevertheless, if this scheme and other such schemes launched by other banks and housing finance companies gain some traction, they will prolong the real estate bubble in the country even more. Hence, instead of reviving real estate, it will make purchasing a home even more difficult. At the same time, I don’t think SBI is taking on an undue risk by launching this scheme. But it remains to be seen how other banks enter this space. If they lower lending standards by increasing the loan eligibility further, we may have a problem.
The column originally appeared on the Vivek Kaul Diary on February 2, 2016