I got an e-mail from one of the regular readers at EMICalculator.net. He brought to my notice an aspect I had failed to cover in my earlier post on Home Loan Protection Plans (HLPPs).
Case Summary
His father had taken a loan of Rs 8.95 lacs for a tenor of 17 years from a leading housing finance company. Let’s refer to the housing finance company as AHFC in this post. His father had been sold a HLPP to cover the home loan amount in the event of his demise. Last year, his father passed away. The insurance company settled only Rs 4.32 lacs while the outstanding loan amount was Rs 8.45 lacs. This came as a shock to the family. His father used to tell his mother that if something were to happen, the insurance loan will take care of the home loan.
That certainly does not hold true in this case. The family needs to arrange the remaining amount to settle the loan. What went wrong? Despite purchasing the life insurance to cover the loan amount, the family is still in financial trouble.
Note: I have taken permission from the reader to share his story with you. The reader preferred not to disclose name of the housing finance company and the insurance company.
Related: ICICI Bank Home Safe Plus — A Review
Why Did This Happen?
There are many reasons.
- The premium for HLPP was Rs ~71,000. A significant amount considering the amount of loan. The insurance premium was clubbed with the loan amount. Hence, the total loan amount became Rs 9.67 lacs (Rs 8.95 lacs + Rs 71,000). However, the life coverage is only for Rs 8.95 lacs (the home loan amount).
- The life cover was a reducing cover HLPP. The insurance cover was only for the outstanding loan amount as per the Original EMI schedule.
- The loan sanction interest rate was 12%. So, the EMI was Rs 11,140. However, the insurance plan was at the rate of 11% p.a. Why the interest rate (as per insurance plan) was lower than the sanctioned interest rate is something only AHFC can answer. We will try to understand how this will cause problems later in the post.
- The home loan was a floating rate. After the borrower took the loan, the interest rate must have gone up leading to slower repayment of principal.
What Is a Reducing Cover HLPP?
Under a Reducing cover HLPP, the Sum Assured is equivalent to the outstanding loan amount as per the Contracted EMI schedule (as per the EMI schedule mentioned in the policy certificate).
Note: Contracted EMI schedule may well be different from the Original EMI schedule (as per loan agreement). More on this later.
Though it may sound like an acceptable alternative, there is a big issue with such plans. The insurance company will settle the claim only as per the Contracted EMI schedule. For the insurance company, it does not really matter what the actual loan outstanding is.
In this case, the loan was a floating interest rate loan. If the interest rates go up in the interim, the actual outstanding loan amount will be greater than the outstanding amount as per the Contracted EMI schedule. In such a case, the payment from insurance company in the event of death of the policyholder will be less than actual outstanding loan amount. Confusing? Let’s look at how the EMI based repayment plans work.
How EMI Based Repayment Works?
Out of every EMI, a part goes towards interest payment and remaining goes to settle the principal amount. This is better explained with the help of an example. Let’s consider a loan of Rs 20 lacs, interest rate of 10% and tenor of 15 years. EMI for such loan will be Rs 21,492. Out of each EMI installment of Rs 21,492, a part will go towards interest payment and remaining towards principal repayment.
How much interest and how much principal?
Interest portion= Principal O/s at the beginning of month * Interest rate/12
| Month | O/S Loan Amount at the start of month (A) | EMI (B) | Interest Payment C=(A)*10%/12 | Principal Repayment (D)=(B)- C | O/S loan amount at the end of month (E) |
| 1 | 2,000,000 | 21,492 | 16,667 | 4,825 | 1,995,175 |
| 2 | 1,995,175 | 21,492 | 16,626 | 4,866 | 1,990,309 |
| 3 | 1,990,309 | 21,492 | 16,586 | 4,906 | 1,985,403 |
| 4 | 1,985,403 | 21,492 | 16,545 | 4,947 | 1,980,456 |
| 5 | 1,980,456 | 21,492 | 16,504 | 4,988 | 1,975,467 |
| 6 | 1,975,467 | 21,492 | 16,462 | 5,030 | 1,970,437 |
| 7 | 1,970,437 | 21,492 | 16,420 | 5,072 | 1,965,366 |
Now, let’s change the interest rate to 12% p.a. You can see the outstanding loan amount goes down slowly in case the loan interest rate is higher. In this case, I have changed to EMI from Rs 21,492 to Rs 24,003.
| Month | O/S Loan Amount at the start of month (A) | EMI (B) | Interest Payment C=(A)*12%/12 | Principal Repayment (D)=(B)- C | O/S loan amount at the end of month (E) |
| 1 | 2,000,000 | 24,003 | 20,000 | 4,003 | 1,995,997 |
| 2 | 1,995,997 | 24,003 | 19,960 | 4,043 | 1,991,953 |
| 3 | 1,991,953 | 24,003 | 19,920 | 4,084 | 1,987,869 |
| 4 | 1,987,869 | 24,003 | 19,879 | 4,125 | 1,983,745 |
| 5 | 1,983,745 | 24,003 | 19,837 | 4,166 | 1,979,579 |
| 6 | 1,979,579 | 24,003 | 19,796 | 4,208 | 1,975,371 |
| 7 | 1,975,371 | 24,003 | 19,754 | 4,250 | 1,971,122 |
What if I do not increase the EMI? Well, the bank will increase the tenor. In this case, the outstanding loan amount goes down even slower.
| Month | O/S Loan Amount at the start of month (A) | EMI (B) | Interest Payment C=(A)*12%/12 | Principal Repayment (D)=(B)- C | O/S loan amount at the end of month (E) |
| 1 | 2,000,000 | 21,492 | 20,000 | 1,492 | 1,998,508 |
| 2 | 1,998,508 | 21,492 | 19,985 | 1,507 | 1,997,001 |
| 3 | 1,997,001 | 21,492 | 19,970 | 1,522 | 1,995,479 |
| 4 | 1,995,479 | 21,492 | 19,955 | 1,537 | 1,993,941 |
| 5 | 1,993,941 | 21,492 | 19,939 | 1,553 | 1,992,389 |
| 6 | 1,992,389 | 21,492 | 19,924 | 1,568 | 1,990,821 |
| 7 | 1,990,821 | 21,492 | 19,908 | 1,584 | 1,989,237 |
This Is What Happened in Case of This Loan
Interest rate went up. EMI remained constant. The Actual outstanding loan amount went down much slower than outstanding loan amount as per Original EMI schedule. Though the reader could not share the entire details about how home loan interest rates were passed to his father, the interest rate had gone at least as high as 16.1% at one point of time. And insurance company thought (contracted) that the interest rate was only 11% p.a.
Let’s Look at the Numbers
After looking at the documents, it was clear that the interest rate as per insurance company was 11% p.a. As per the loan sanction letter, the interest rate is 12% p.a. The loan sanction letter was dated June 26, 2007 and the insurance certificate was dated August 2, 2007. The dates are not so far to explain difference of 1%.
Why this difference of 1% p.a.? Only AHFC and the insurance company can answer. Hence, even before anything began, the AHFC put the borrower at disadvantage. This difference of 1% ensured that the Sum Assured went down much faster than the home loan amount.
| As per Insurance Company (at 11% p.a.) | What Really happened (at say 13% p.a.) | |||||||||
| Year | O/S at start of year | Annual EMI | Interest Paid | Principal Repaid | O/S at end of year | O/S (includes insurance premium) | Interest Paid | Principal Repaid | O/S at end of year | |
| 1 | 895,000 | 133,680 | 96,618 | 37,062 | 857,938 | 967,000 | 125,218 | 8,462 | 958,538 | |
| 2 | 857,938 | 133,680 | 92,330 | 41,350 | 816,588 | 958,538 | 124,049 | 9,631 | 948,907 | |
| 3 | 816,588 | 133,680 | 87,545 | 46,135 | 770,453 | 948,907 | 122,720 | 10,960 | 937,947 | |
| 4 | 770,453 | 133,680 | 82,206 | 51,474 | 718,979 | 937,947 | 121,207 | 12,473 | 925,474 | |
| 5 | 718,979 | 133,680 | 76,249 | 57,431 | 661,548 | 925,474 | 119,486 | 14,194 | 911,280 | |
| 6 | 661,548 | 133,680 | 69,604 | 64,076 | 597,472 | 911,280 | 117,526 | 16,154 | 895,126 | |
| 7 | 597,472 | 133,680 | 62,189 | 71,491 | 525,981 | 895,126 | 115,297 | 18,383 | 876,743 | |
| 8 | 525,981 | 133,680 | 53,916 | 79,764 | 446,217 | 876,743 | 112,759 | 20,921 | 855,822 | |
| 9 | 446,217 | 133,680 | 44,686 | 88,994 | 357,222 | 855,822 | 109,871 | 23,809 | 832,014 | |
| 10 | 357,222 | 133,680 | 34,387 | 99,293 | 257,930 | 832,014 | 106,585 | 27,095 | 804,919 | |
| 11 | 257,930 | 133,680 | 22,897 | 110,783 | 147,147 | 804,919 | 102,845 | 30,835 | 774,084 | |
| 12 | 147,147 | 133,680 | 10,078 | 123,602 | 23,545 | 774,084 | 98,589 | 35,091 | 738,993 | |
| 13 | 23,545 | 133,680 | (4,225) | 137,905 | (114,361) | 738,993 | 93,745 | 39,935 | 699,058 | |
| 14 | (114,361) | 133,680 | (20,184) | 153,864 | (268,224) | 699,058 | 88,233 | 45,447 | 653,611 | |
| 15 | (268,224) | 133,680 | (37,989) | 171,669 | (439,893) | 653,611 | 81,960 | 51,720 | 601,890 | |
| 16 | (439,893) | 133,680 | (57,854) | 191,534 | (631,427) | 601,890 | 74,821 | 58,859 | 543,031 | |
| 17 | (631,427) | 133,680 | (80,018) | 213,698 | (845,125) | 543,031 | 66,696 | 66,984 | 476,047 | |
Let’s consider only the first part of the above table. At 12%, EMI comes to Rs 11,140. Annual EMI is Rs 133,680 (Rs 11,140*12). The insurance company used the same EMI (at 12%). At 11% p.a., the EMI should have been Rs 10,496. Double whammy for the borrower!!! How?
As explained in an EMI based repayment schedule, part goes towards interest payment and remaining goes towards principal repayment.
- At 12% p.a. The EMI is Rs 11,140. In the first month, you pay Rs 9,670 of interest of Rs 1,470 of principal.
- At 11% p.a., the EMI is Rs 10,496. In the first month, you pay Rs 8,864 of interest and Rs 1,632 of principal.
However, with EMI of Rs 11,140 and interest rate of 11% p.a, you pay Rs 8,864 of interest and Rs 2,276 of principal in the first month. Hence, with EMI (at 12%) and applicable interest rate at 11% (as per insurance company), his loan would get repaid at an even faster pace (as per the insurance company). You can see in the above schedule the loan gets repaid in little over 12 years while the actual loan prepayment term is 17 years.
To give benefit of doubt to the housing finance company, you may argue that since we tend to aggressively prepay our home loans, the housing loans are finished much ahead of schedule. i.e., the actual outstanding amount, in practice, goes down much faster than the original schedule. Hence, by offering insurance at lower interest rate (and ensuring outstanding principal amount goes much faster the loan schedule), the housing finance company is actually lowering premium cost for the borrower. However, in my opinion, this is irresponsible on the part of housing finance company. It beats the purpose behind purchasing HLPP. Moreover, considering the size of loan (~Rs 8.5 lacs for home loan), it will be not be unwise to infer that the borrower’s family may not be able to manage deficit amount in the event of demise of the borrower.
Quite possible AHFC was only concerned about hefty commissions from insurance sale. If AHFC was concerned about borrower interest, this would not have happened.
Now, let’s move to the second part of the table. I have considered the movement of interest rate for the borrower. Though the home loan interest rate would have fluctuated during the course of the loan, I have considered a flat rate of 13% p.a. for the home loan for demonstration purposes. At the end of 8th year, the difference is about Rs 4.1 lacs. At the end of 12th year, the difference is over Rs 7 lacs. And the home loan amount was only Rs 8.95 lacs.
Where is the security that the borrower would have thought his family had? You can see what a poor product structure and a blind faith on banks and other financial institutions can do. All along, his father thought he was covered. Who should be blamed? In my opinion, look no further than AHFC. And don’t forget the insurance company too. It could have been a partner in crime. This case highlights another shortcoming of a HLPP and why plain vanilla term life plan should be preferred over a HLPP.
What Should You Do?
You cannot always rely on banks or financial institutions to look after your interest. You must be aware. Here is what you must do.
- Go for a pure term cover instead of a HLPP.
- If you must go for a HLPP, go for a level cover HLPP (instead of a reducing cover). In most cases, a level cover HLPP will be better suitable than a reducing cover HLPP.
- If you have to go with a reducing cover, always keep track of the insurance cover and the actual outstanding loan amount. If the difference between the two values has grown beyond comfort, try to prepay some loan amount to get those numbers closer. This is more likely a problem with floating rate loans.
Note: I advised the reader to take this analysis to take the numbers to AHFC and seek explanation. AHFC is currently looking into the case.
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