Source: The Economic Times.
The repayment of housing loans is through equated monthly instalments (EMIs). Some banks provide a step-up EMI facility to borrowers. The step-up EMI facility intends to reduce the repayment burden in the initial years and helps in increasing the loan eligibility of the borrower. The facility helps young borrowers, who intend to borrow early but at the same time do not have high incomes and cannot afford higher EMIs in the initial years. However, over time, as their income increases, they can afford to pay higher EMIs. It is to be noted that in this process, the borrower takes on a higher interest rate risk if the loan is based on a floating rate of interest. A rise in rates would mean that a portion of the interest would remain unrealised and added to the borrower's principal.
Since a large part of the initial instalments go towards interest payment, the borrower can avail of tax benefits for a longer period. Interest on the loan involves a cost. However, tax benefits tend to reduce the cost of the borrowing. This way the borrower can deploy his savings in other investments schemes which offer a better rate of return. Under this facility, the EMI portion is recovered in parts. During the first few years, a lower EMI is to be paid by the borrower. During the latter part of the loan tenure, EMIs are stepped up i.e. increased. This way the burden of repayment in the initial years is reduced on the borrower. The principal repayment under the step-up loan may start immediately, thereby reducing interest rate risk on the customer. In other cases, the EMIs for the first few years are just enough to cover the current interest rate. The process of step-up can be in different phases. In some cases, two phases are offered - one at a lower rate and the other at a higher rate. In other cases the step-up can be a gradual process. It can be done yearly or every five years, or some other time period. Some banks also offer the step-up facility with fixed interest rates, but the rate of interest on such loans is higher than the floating rates. The step-up facility involves a lower outgo in the initial periods. Borrowers who are likely to earn more in future can avail this facility to get higher loans and adjust their cash flows over a period of time. The borrowers need to keep in mind the fact that in the step-up facility, the interest rate risk exposure is quite high. In the initial years, the interest component is more and the principal component is less, lower EMIs in the initial year would mean that lower principal is being repaid. This deferral of principal to the later part of the loan tenure will increase the interest cost of the loan. This may turn out to be very costly in case of floating rate loans because in case the interest rates increase, the higher interest would have to be paid on a higher outstanding principal loan amount. In case of a rise in interest rates, the difference is recovered by way of higher EMIs towards the end of the loan tenure.
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