Should You Take a Loan for House Downpayment?

Why do we have to make down payments for home purchases? Why can’t the banks lend the full amount for the purchase?

Two reasons.

Firstly, the banks get a wider security cushion while lending. So, if the bank lends Rs 80 lacs for purchase of Rs 1 crore house, in the event of default, the bank has greater chances of recovering its money.

Secondly, the down payment also brings the borrower’s skin in the game. If the borrower does not repay the loan, the bank will repossess and auction the property. The borrower will get only the portion of proceeds left after squaring off the bank loan and interest. Hence, the borrower has greater incentive to repay the loan because of down payment. Additionally, from the bank’s perspective, down payment is an indicator of repayment ability of the borrower.

Depending on the size of the loan and internal credit policies, the banks may insist on 10% to 25% down payment. You can always pay a bigger upfront payment. And in a way, that’s a good thing since that will reduce the size of the loan.

However, real estate prices are rising. And a 20% down payment on a Rs 1 crore property means paying Rs 20 lacs upfront. That’s not a small amount. Ideally, this money should be paid from your own savings. However, if you have not accumulated such an amount, you can borrow from friends/family. Or take a personal loan. However, a personal loan will be quite expensive compared to a home loan.

What if I were to tell you that you could get a no-cost EMI loan for making down payment for the house?

Yes, you can. Enter Home Capital. This lender offers a Home Down Payment Assistance program. This is just a fancy name for a loan. As per lender’s website, you can get up to 50% of your down payment requirement. You can repay the loan in the 3, 6 or 12 installments. The key is that you don’t have to pay any interest. You just need to return the principal amount over the next few months. Good for you. Now, you might ask, how does the lender make money?

And the Lender Must Make Money

We noted, in our previous post, that the lender must be compensated for the risk taken. There is no business model without a revenue model. As I understand, the RBI prohibits banks from offering zero percent loans. Not sure if this restriction extends to NBFCs too.

I see 2 possibilities.

First, no-cost EMI schemes are funded through upfront discounts from the merchants. Now, as I understand, Home Capital shares this down payment assistance for only select projects. Therefore, it is possible that the developers may be offering them a discount. For instance, you have to pay Rs 5 lacs to the developer. But the lender pays only say 4.85 lacs to the developers and recovers Rs 5 lacs from you over the next few months. The difference is the implicit interest cost. Or there could be alternate revenue sharing/referral arrangement between Home Capital and the developer. As a borrower, you don’t have to worry about the arrangement between the lender and the developer. However, you might want to make sure if you could have bought the property at a lower price if you had approached the developer directly.

Secondly, the lender charges a processing fee for the loan. As per the company website, for a 3 month no-cost EMI scheme, the company charges 1.99% + GST as the processing fee. So, if the down-payment loan is Rs 5 lacs. You will pay Rs 10,000 + GST as processing fee. So, effectively, the company pays Rs 4.9 lacs and recovers Rs 5 lacs over 3 months. This is 12% p.a. return on capital. As a borrower, since you pay the GST too, your effective cost is 14.37% p.a. Not too different from a personal loan. I am not clear if the processing fee goes up if you opt for a longer repayment tenure (6 or 12 months).

While I might be wrong, I think there is some referral compensation/revenue sharing arrangement between the lender and the developer.

But There Is a Bigger Problem

While down payment seems a burden on the home buyer, it does serve a purpose. To some extent, it ensures that you don’t buy a house you can’t afford. After all, you must pay 10%-20% of the purchase amount from your own savings. That caps the cost of the house in relation to your savings.

If houses could be purchased with zero percent down payment, then many buyers will end up taking home loans to buy very expensive homes. The loans for down payment reduce the amount you must pay from your own savings, which dilutes the purpose of down payment.

Additionally, you must ask yourself, why don’t you have money for down payment? This is better understood with the help of an example.

Let’s say, you want to buy a house with an all-in cost of Rs 1 crore. Let’s further assume that the LTV for the home loan is 80%. This means the bank will fund only 80% of the overall cost. You must pay the remaining 20% from your savings/own funds.

The bank gives a loan of Rs 80 lacs. At an interest rate of 8% p.a. and a tenure of 20 years, the EMI will be Rs 66,915.

Usually, the banks consider a Fixed Obligations to Income ratio (FOIR) of 40%-50%.

FOIR = Your total monthly loan EMI (including the loan applied for) ÷ Net monthly income

So, if your net monthly income is Rs 100,000 and the FOIR for the bank is 40%, the bank won’t offer a loan for which the EMI is more than Rs 40,000 (Rs 1 lac X 40%). Note that the banks consider the existing loans from other banks too. For instance, you are already paying 2 EMIs of Rs 5,000 and Rs 10,000 from HDFC Bank and ICICI Bank respectively.  Now, if you go to Axis Bank (and let’s say Axis Bank has FOIR of 40%), the bank won’t be comfortable offering you a loan where the EMI breaches Rs 25,000 (Rs 40,000 – Rs 5,000 – Rs 10,000).

Limiting FOIR is a prudential measure on part of the bank. Home loan EMI won’t be your only expense. You would have other expenses to meet too from your income too. By capping FOIR, the banks ensure that you don’t over-borrow and subsequently struggle with loan repayment.

So, with EMI of Rs 66,915 and FOIR of Rs 40%, your net monthly income (post-tax) should be ~ Rs 1.67 lacs (and this is minimum income).

The down payment requirement is Rs 20 lacs (Rs 1 crore – Rs 80 lacs of loan). Rs 20 lacs is about 12 months of your net monthly income.

Now, if you must consider a loan for house down payment of Rs 20 lacs, that means you have not been able to accumulate Rs 20 lacs.

While I do not want to stand in judgement, if you have not been able to accumulate even 12 months of your net monthly income, we have a problem. You are simply NOT saving enough. Remember Rs 1.67 lacs was minimum income for an EMI of 66,915. Your income could be even higher, and in that case, Rs 20 lacs is an even lower multiple of your net monthly income.

I understand I shouldn’t make a sweeping statement. Your ability or intention to make down-payment could be low for many reasons. You might have had an unplanned expense recently. OR you do not want to utilize all your savings for house down payment and keep some money aside for emergency fund. Or you had kept money in stocks and the stocks are currently down. You don’t want to sell these stocks at depressed valuation and want to wait for the markets to recover.

Moreover, a loan for house down payment is just another loan. You need to return this money over the next few months. That will put additional pressure on your cash flows. Remember FOIR.

It is good to have options. And Down payment assistance program (from Home Capital) is one such option and could be used as a last resort. However, if you are planning to buy a house soon, you must plan and accumulate funds for down payment gradually.

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