HOUSING LOANS - TO FLOAT OR NOT TO FLOAT?

Interest rates in India have been rising relentlessly and home loan borrowers - both existing and potential - are a baffled lot. Those who opted for floating rates a couple of years back when interest rates were falling are now required to shell out larger sums of money (for a longer term in many cases). The potential borrowers - those who are planning to buy a house - are looking on helplessly as both the price of residential property and the housing loan rates move northwards.

Should one opt for a fixed rate or a floating rate loan? How far will the interest rates go from here? Is it wise to lock in a fixed rate when interest rates are so high? As housing loans are long-term in nature - typically 15-20 years - it's important to understand the nature of the risks involved and to evaluate the risk-reward equation - the pros and cons - of all the options.

When you opt for a floating rate loan, you expose yourself to the vagaries of interest rate movements over the entire life of the loan. The expected pay-off for bearing the interest rate risk is to benefit from a possible fall in interest rates. In case of a fixed rate loan, the risk of interest rate movements is borne by the bank, while the borrower is immune to interest rate changes (at least his cash outflows will not change during the entire loan period). However, if interest rates fall, there will be a potential loss as you will earn lesser interest on your savings (deposits) but keep paying higher interest rate on the loan. As banks have to bear the risk in case of fixed rate loans, they price in the risk and such loans are available at a premium campared to floating rates. For example, if a 15 year floating rate loan costs 10% and a fixed rate loan of same maturity is available at 12%, the 2% premium is charged by the bank to cover its risk because it is bearing the interest rate risk in case of a fixed rate.

Interest rate movements are cyclical and a period of 15-20 years is enough to see all the phases of the movement. We can possibly see two to three complete cycles with rates rising, then stabilising at higher levels before starting a downward movement, again falling for some time, then stabilising at lower levels, rising again and so on. If this is the case, ideally it should not make a difference over such a long period of time whether it is a fixed rate or a floating rate. However, it has been seen that while the banks will immediately pass on the rising costs to the borrowers, they don't show the same promptness in giving the benefits of falling interest rates. A repo rate hike as small as 25 basis points, an increase in cash reserve ratio or even a hawkish statement by a Reserve Bank official lead to rate increases of 50 to 100 basis. It is basically the inefficiency or non-transparency of the floating rate mechanism which skews the balance against the borrowers.

As it is difficult to take a call on interest rate movements over a long period of time (even the best forecasting tools cannot predict how interest rates will move over next 15 years), the decision has to be based on a trade-off - how much risk you want to take given your current stage of life (i.e. whether you are young, middle-aged, approaching retirement, etc.) and expected income pattern (i.e. whether you can absorb unexpected changes in the cash outflows). Considering the near tem outlook, it will be advisable to go for a fixed rate. As Indian economy is on a high growth trajectory and doesn't show any signs of fatigue (plus shows some signs of overheating), interest rates are expecetd to keep moving up in near future. However, if you are young and don't mind rising EMIs in the initial few years but would like to benefit from lower interest rates later, you can go for a floating rate. But keep the option to switch to a fixed rate later if required and see its cost.

As an alternative to pure fixed or floating rate loans, some banks and HFCs are also offering hybrid loans. In such loans, a part of the loan will be at a fixed rate and remaining will be floating (ideal for those who are not able to decide between fixed and floating !). Another variant is based on duration - the rate will be fixed for the first 2-3 years and will become floating afterwards. These donot make much sense to me, as anything that looks seemingly attractive will have a premium based on the bank's view on interest rates. Bankers will come up with more innovative products to further confuse the borrowers, as the interest rate scenario gets more hazy. Personlly, I will stick to the idea of fixed rate as it implies a known mothly outgo for a fixed time. No shocks.

And, as for the floating rate loans, I would like to see two changes in the mechanism to make it more meaningful. One, rates are reset at a pre-determined frequency, say every three months or six months (and not every time the bank decides to change its PLR). Two, the rates are linked to some transparent market benchmark and not the arbitrarily determined PLR - for exmaple, average of daily MIBOR over the period or yield on 10 year government bond (plus a spread). These will make the changes more predictable and transparent for the borrower.

I am writing this article based on the request of Amit Shekhar who is planning to buy a house. Hope this will be useful. All the best Amit and all prospective home loan borrowers.

THE SUSPENCE IS OVER..
BoJ Raises Interest Rate

The Bank of Japan has raised its overnight lending rate to 0.5 percent, saying that prolonging a low-interest-rate policy could hamper economic growth. This has been one of the closest calls for the market as opinion was sharply divided amidst strong fourth quarter growth numbers but lingering doubts on sustainability of the economic recovery.

The central bank of the world's second largest economy said in a statement that the the economy is likely to continue its moderate expansion with a virtuous circle of production, income and spending in place. The statement indicated that future adjustments on interest rates will be gradual.

Here are some major points from the statement--

1. Uncertainties over the future course of overseas economies, including that of the United States, are abating, and this is likely to reinforce the prospects of continued increase in corporate profits and business fixed investment.
   
2. With respect to private consumption, the weakness observed in the last summer seems temporary, and it is judged that private consumption is on a moderate increasing trend.
   
3. Consumer prices (excluding fresh food) have been registering small increases on a year-on-year basis, and it is possible that the rate of change will be around zero in the short run. From a longer-term perspective, however, consumer prices are likely to increase as a trend, since the utilization of resources such as production capacity and labor has been increasing and the economic expansion is expected to continue.

WILL FUKUI RAISE INTEREST RATES ?

As Bank of Japan's policy board starts its two-day meeting on 20th February, opinions are divided on whether inerest rates will be raised. The board at its last month's meeting voted 6-3 to keep borrowing costs on hold, with three dissenting members having favoured a rate increase. The central bank of the world's second largest economy ended its zero rate policy last July when it raised the overnight lending rate to 0.25%.

Each piece of economic data since then has been closely monitored and speculations on the timing of next rate increase have been doing the rounds. There are, however, lingering doubts on whether the economy is ready for higher interest rates. The Japanese economy, after growing steadily for about five years, is showing signs of faltering. And, the political leadership has expressed its preference for low interest rates saying that any increase now may hurt the recovery.

According to the latest figures released last week, Japan's economy posted strong growth in the last quarter of 2006 - an annualised rate of 4.8%, highest in almost three years. Consumer spending rose 1.1% rebounding from an equal drop in the July-September period and business spending increased 2.2% in the fourth quarter, following a revised 0.8% increase in the third quarter. However, there are no signs of inflation yet and this makes the central bank's pursuit of a rate increase difficult. Core consumer prices rose 0.1% in December, slowing from 0.2% in the previous month.

Besides the figures of economic growth and inflation, one factor that BoJ will consider is the so-called yen carry trades. This is a transaction that looks quite simple - borrow in yen (at very low rate of interest) and invest in higher-yielding assets in other markets (such as US treasury bonds). But the build up of positions has been so massive that it is being seen as a source of potential financial crisis. So much so that the G-7 group earlier this month warned investors against making "one-way bets". A rapid unwinding of such positions may lead to huge losses for the investors. And may be collapse of many hedge funds?

Dow Jones dream run continues

The Dow Jones Industrial Average reached an all-time high marking a record for the third day in a row, as Federal Reserve Chairman Bernanke painted a broadly optimistic picture of the economy. The 30-stock index has risen seven straight months - the longest winning streak since 1995 - and has gained 2.4% in 2007. It closed at 12,767.57 this Friday, basking in the optimism generated by Bernanke's testimony and positive data on wholesale prices, while shrugging off another set of data that showed a continued slowdown in the housing market.

The Fed Chairman sounded less hawkish in his semi-annual congressional testimony than expected, spurring expectations that interets rates will remain on hold and will be cut later this year. He assessed that there were some indications that inflation pressures were beginning to diminish. Since there was much noise in monthly data, it may be some time before the Fed could be confident that underlying inflation was moderating as anticipated. He noted that core inflation rate remained somewhat elevated. However, if activity expanded over the next year or so at a moderate pace as anticipated by the FOMC, pressures on both labour and product markets should ease modestly. Consumer spending has been the "mainstay" of growth, and the worst housing slump in more than a decade won't have a significant effect on other parts of the economy, Bernanke said.

Reflecting anticipation of lower rates, the yield on the benchmark 10-year U.S. Treasury note has fallen to 4.69 percent.

Inflation in India rises to 6.73%

Defying all the monetary and fiscal measures taken by the government and the central bank in the past few months, inflation continues its upward march. The annual inflation measure based on wholesale price index has returned a reading of 6.73 per cent for the week ended February 3, up from the previous week's 6.58 per cent and highest in about 2 years. What's worse is the inflation estimate for the week ended Dec. 9 has been revised to 5.63 percent from 5.32 percent. It's a usual practice to revise the inflation data with a lag of two months on additional price data.

The rise in inflation figures is being driven by the rapid economic growth and credit expansion, together with supply constraints in agricultural commodities and food articles. While the RBI has been pursuing a gradual tightening to avoid liquidity overhang, the central government has taken measures like ban on export of certain items, easing import restrictions, cuts on customs duties, restriction on futures trading of some essential commodities and cut in petrol and diesel prices. With the combined effect of these measures, inflation numbers should moderate over next couple of months. However, as the economy has taken off into an unchartered territory of high growth, it is expected that the central bank will continue to raise rates and do everything at its disposal to actively manage the liquidity.

Bond markets have been in a virtual free fall in this scenario of rising inflation and monetary tightening (and 'to be continued' signs). The benchmark 10 year yield is above 8 per cent.

China raises reserve ratio

In a move to temper the staggering pace of economic growth and curb inflationary pressures, China's central bank has raised the reserve ratio by 50 basis points. Commercial banks will now be required to set aside 10% of their deposits in cash reserves. This is the second hike in 2007 and fifth since last July.

The People's Bank of China is concerned that continued growth will stoke consumer prices as the economy marks a record trade surplus. Mounting trade surplus along with strong FDI inflows are adding to the excessive liquidity in the banking system and the central bank has taken a slew of measures to slow the pace of lending.

"Since 2006, the People's Bank of China has used a combination of monetary tools to soak up liquidity in the banking system and has achieved some results," the central bank said in a statement posted on its web site. "But the surplus in international payments remains large and the pressure on loan expansion is still relatively big so it is necessary to again increase the reserve ratio," it said.

China's economy, the world's fourth-largest, expanded 10.7% in 2006. And consumer prices returned a rise of 2.2% for the month of January - lower than the previous month's 2.8%, still high enough to call for continued tightening bias.

War on inflation intensifies - CRR raised again

The Reserve Bank of India has announced another hike in the cash reserve ratio, as inflation continues to surge despite a slew of monetary and fiscal measures taken in the last couple of months. The 50 bps hike takes the CRR - the balance that banks need to maintain with the central bank - to 6% and will be effective in two phases of 25 bps each, first phase kicking in on 17th February and second phase starting 3rd March. The move will impound about Rs. 14,000 crore out of the banks' deposits.

It was on 8th December 2006 that the RBI had last raised CRR by 50 bps, absorbing around Rs 13,500 crore. This was followed by a 25 bps increase in the repo rate on 31st January. RBI is worried about the spiraling inflation and has been taking measures to avoid overheating of the economy as it continues to grow ferociously. See a detailed analysis of the interest rate scenario and RBI's actions here.

The Indian economy is expected to grow at 9.2% in FY2007 on the back of 9% growth last year. The annual wholesale inflation rate has touched 6.58% for the week ended 27th January - a full percentage point higher than RBI’s target for the current fiscal.

Besides the surging inflation numbers, the recent move seems to have been triggered by the rise in liquidity from RBI's intervention in the forex market in the last few days. RBI has been buying dollars to halt the appreciating rupee as a strong domestic currency affects the country's exports.

The CRR hike is bound to have an impact on banks' lending rates, including those on home loans, auto loans and personal loans. In the weeks following the recent repo rate hike, some of the private sector banks have already raised their lending rates. Public sector banks, which constitute three-quarters of India’s banking industry refrained from doing so as they were advised by the finance minister to maintain the current rates, especially on housing loans. They may have to follow suit now, as the liquidity squeeze puts pressure on their cost of funds.

ECB holds interest rate, may raise in March

The European Central Bank has decided to keep its key interest rates on hold at 3.5%, waiting to see if its last increase in December can keep inflation at bay and hinting that a hike may come in March. The ECB President Jean-Claude Trichet said "strong vigilance" was needed to avoid "risks to price stability" – a statement being seen by the market as a clear signal for a rate hike next month. The term ‘vigilance’ seems to have acquired a new meaning for the followers of Trichet-speak - each of the last six times Trichet used the word vigilance, a rate increase was handed down the next month.

The key eurozone economies have had a strong start to 2007. Unemployment has fallen in France and Germany, with consumer confidence remaining strong, despite Germany's decision to increase value added tax (VAT) from 16% to 19%. While growth is expected to remain strong, wage pressures are mounting. The latest round of pay negotiations in Germany will be keenly watched. Inflation in the euro zone was 1.9 percent in December for a third straight month, at its recommended level of just under 2 percent.

Meanwhile, Bank of England also held official interest rates steady at 5.25 percent after a surprise increase last month of a quarter of a percentage point.

ICICI Bank raises home loan rates

Following the repo rate hike announced by RBI in its quarterly policy review on January 31, ICICI Bank has raised interest rates on all advances including home loans by one percentage point. The fixed rate home loan will now cost 12.5% and floating rate home loans between 9.5% and 10.5%.

The rate hike by India’s largest private sector lender comes just a day after the Finance Minister, Mr P. Chidambaram, asked public sector banks to maintain interest rates on home loans at current levels. While it may be politically correct for the public sector banks to hold on to current rates, the increasing pressure on borrowing costs will force them to raise rates sooner or later. Given the huge growth in the economy, the Reserve Bank of India has been taking steps to cool down inflationary trends and to avoid building up of asset price bubbles. There are clear indications that the rate tightening cycle – “measured increase in interest rates” - will continue.

Interest rates on housing loans have risen substantially in the past couple of years. For the existing floating rate borrowers, each reset will mean higher outgo. So far, the upward revision in the rates was being adjusted by banks by increasing the maturity period. Now the banks have started increasing monthly instalments. This may also lead to a rise in delinquencies in a segment that has historically been seen by banks as less risky.

US hopeful of soft landing

Interest Rates Unchanged

The U.S. Federal Reserve has left interest rates unchanged at 5.25 per cent for the fifth time running. The widely expected move comes amid signs of the US economy staying reasonably strong and inflation being more under control. While recognizing “somewhat firmer economic growth” and “signs of stabilization” in the housing market, the rate-setting Federal Open Market Committee has expressed growing confidence that inflation is running lower. "Readings on core inflation have improved modestly, and inflation pressures seem likely to moderate over time," the central bank said. At the same time, it also repeated its caution that "some inflation risks remain" - a sign that it is likely to keep its benchmark rate at current levels for the near future (or, may even raise further). The US economy grew faster than expected in the last three months of 2006, as increased consumer spending offset a housing market slowdown. The GDP rose at an annual rate of 3.5% from October to December, while the growth rate for 2006 as a whole was 3.4%, more than 2005's 3.2% expansion. The Fed's policy aim is to achieve a “soft landing” - a mild slowdown in growth that would cool down inflationary pressures but not spiral into a recession.

On interest rates and home loans

Fellow blogger Amit Shekhar has requested for a detailed analysis of the recent repo rate hike by RBI and its impact, particularly on home loan rates. Amit authors two great blogs Indian Thinking and Bombay Today. He writes on contemporary issues and trends in areas as diverse as technology, business and crime. His writings are deep and thought-provoking. “ …. blogging is my way of connecting to the world, cause i believe there are like minded and fresh thinkers around to praise advise and encourage.”, Amit says.

Here's my take on the repo rate hike announced by RBI in its quarterly policy review on 31st January. I have tried to analyse the significance of repo rate as the signal rate for the economy, reasons for the monetary tightening in the context of current and evolving economic situation, future course of interest rates and housing loans market. I believe housing loans will gradually lose their status as the most preferred segment for the bankers and will become costlier for the consumers as interest rates in the economy rise further and policy preferences change.

As Indian economy and the interest rate cycle are at a very interesting stage, I will be writing more on the subject in the coming weeks. Please give your opinion and feedback.

What is the significance of repo rate?
RBI conducts daily repo auctions as part of its liquidity adjustment facility (LAF). Repo is the short form of repurchase which refers to lending or borrowing against marketable securities (such as government bonds). This is used by RBI as a tool to manage the system liquidity – banks having surplus intraday cash can lend to RBI (at reverse repo rate – currently 6%) and those having shortfall can borrow from RBI (at repo rate – currently 7.50%). Although these are short term (overnight) rates, repo and reverse repo rates are used as the signal rates for the economy.

Why has RBI been raising interest rates?
As Indian economy has been growing strongly, the central bank’s primary concern is to avoid over-heating and a likely surge in inflation (inflation is already beyond the informal tolerance range of 5-5.50%). Typically, periods of high growth culminate into formation of asset price bubbles in pockets of the economy, like stock markets, real estate, etc. By raising interest rates in a measured way, RBI has been trying to cool down inflationary pressures and to avoid the undesirable side effects of high growth like escalating asset prices.

What is the significance of the latest rate hike?
The latest repo rate hike is one step in a series of measures that RBI has been taking in the past couple of years to address the concerns arising from high growth. To be precise, since September, 2004 repo rate has been increased by 125 bps, reverse repo rate by 150 basis points and the CRR by 100 basis points. CRR – cash reserve ratio - is the amount of cash (as a percentage of bank deposits) that banks are required to set aside and maintain with the central bank. A higher CRR will mean banks have lesser money available for lending, hence will charge higher interest rates.

Simultaneously, RBI has also taken measures to avoid building up of asset price bubbles, especially in the real estate sector and has been trying to reduce the flow of funds from banking system into the hot property market (as also other potential ‘trouble-spots’). Towards this end, it has taken steps like increasing the risk weights for housing loans from 50 per cent to 75 per cent, for commercial real estate from 100 per cent to 150 per cent and consumer credit from 100 per cent to 125 per cent, increasing provisioning requirement for standard advances for personal loans, credit card receivables, loans to real estate and capital markets. All this means the borrower will have to pay a higher interest rate for such loans.

More rate hikes to come?
There are clear indications that the rate tightening cycle – “measured increase in interest rates” - will continue. Domestic economy is expected to continue on the high growth trajectory and containing inflation will be high on the monetary policy agenda. Who wants a double-digit growth and double digit inflation? Global trends also point to a continued high interest rate bias. Global growth continues to be strong despite fears of a slowdown in US. Although there are no signs of a runaway inflation growth in the major economies, the central banks do not want to let their guard down.

Will home loan rates rise?
Yes. With loan growth out-stripping deposit growth and liquidity drying up, banks are feeling continued pressure on their borrowing costs. This is evident in the scramble to mobilize deposits and the rise in deposit rates by many leading banks in the recent past. Although there may not be immediate increases because of the latest repo rate increase (this was widely expected), there will definitely be upward pressure on home loan rates because of the overall rise in interest rates in the economy.

Some respite for the banks may come in the Budget if the lock-in period for tax rebate on long term deposits is reduced from 5 years to 3 years – banks would be able to mobilize more deposits. But, another factor that will play against home loan borrowers is a growing feeling among policy-makers, especially in RBI, that there is a good deal of speculative money flowing into the property market (including residential property) through banks. Although the current focus is on reducing the flow of funds into commercial real estate, RBI has made it clear that it is not happy about the bankers going all out to woo the housing loans borrowers. RBI has urged upon banks to re-jig their credit portfolio – from the hot housing loans and personal loans into 'more productive sectors' of the economy. The Governor's worry about the under-performance of agriculture expressed in policy statements is a clear sign of where the central bank wants the bankers to lend. Even the government is likely to give a big push to agriculture sector in this year's budget (and beyond) and banks will be called upon to play a bigger role in this.

I believe, housing loans will gradually lose their status as the most attractive sector for the bankers and become costlier for the consumer, as interest rates in the economy rise further and policy preferences change. Same for personal loans and credit cards.

An update
Indian Bank has announced that it is increasing its benchmark prime lending rate (PLR) by 50 basis points to 12.5 per cent, deposits rates by 25-50 basis points and home loan rates by 25 basis points across all tenors from February 1.