Buying a home is a dream that many hold on to since their childhood. But as we grow we understand the cost of buying a home and salary we have might not match and that we need to save a lot before you get the ability to buy a home.
This was the same dilemma that Rohith was in. He had just moved to a new company where his salary was Rs.5 Lakhs per annum who wants to buy a home. He approached his friend who works in a bank to know what his options are. His friend told him to take a step-up home loan. Rohith confused, asked his friend -
What is step up home loan?
A step-up home loan is where a borrower will pay less EMI at the initial stages of the loan tenure. As time goes by with the increase in the borrower’s salary the loan EMI will also increase.
How does it work?
In this loan the EMI is recovered in pieces, that is in the initial years of repayment the EMI for the borrower will be less. Thus, during the initial stage of the loan tenure, the burden for the borrower is less and increases as time goes by. The borrower need not worry that the EMI will only consist of the interest and not the principle as it is low. The EMI paid each month will have the principle part also reducing the risk for the borrower.
Also, if the borrower gets married and taking our example Rohith’s wife is also earning he can increase the EMI to a higher level which could help finish his home loan faster. The increase in EMI can be as high as 30% and will depend on the age, company, and salary of Rohith and his wife.
The increase in EMI or step up can be done in various levels or stages. It can be a situation where the EMI increases gradually say each year as the Rohith’s salary increases or can be a 2-phase loan repayment where the EMI is constantly low for a set time frame and high after a period.
As mentioned earlier the due to the lower EMI at the initial years of the loan repayment the cost of loan is less, this in turn improves your loan eligibility and approval chances. With the interest being more in the case of EMI the borrower can claim tax benefits where the interest paid on home loans is deductible. This tax benefit can be twofold if the borrower takes a joint loan with their spouse. This reduces the cost of borrowing further.
These loans are availed based on assumptions that the borrower’s salary will increase at a certain rate and the borrower might also go for a higher loan. If the borrower’s salary does not increase as expected, then he/she will be in trouble when the time comes to start paying the higher interest rate. Therefore, when calculating the salary growth, the borrower needs to take into consideration inflation plus 1% to 2% points as fallback each year.
Another disadvantage of this loan is that the borrower will be paying lesser EMI at the starting stages where the interest is more, and principle is less. This loan could become costly for the borrower if the transition of paying higher EMI does not take place as planned. It will be a bigger problem if the borrower has taken a floating rate of interest in which case it will fluctuate according to the market condition.
One must also consider if a couple taking a joint loan divorces or one of the borrower is transferred to a different location due to which the loan EMI could become a big burden for the borrower.
You need to be smart when choosing this loan, especially when fixing the loan amount. As mentioned earlier consider inflation when calculating salary rise. Also choose fixed interest for this loan type as gives you better control over your Emi which is difficult in the case of floating rates.