Long Term & Housing Finance in Construction

Finance to construct, purchase or renovate a development repayable over long term -
The borrower is usually a person intending either to occupy the development or let/lease it to a tenant. Loan is issued based on the income of the borrower, and developed property is mortgaged to lender. Borrower cannot sell the property until the loan is settled.

As, these loans are repaid in installments over very long span of time say, 10-20 years and they are called long-term loans. For example ordinary housing finance is a long term loan. Long-term loans are usually given by financial institutions which can hold the loan for long term. This includes insurance companies, provident fund or specialized housing finance institutions. Large banks which can hold funds for long term may also provide long-term finance.

Difference between long term finance, short term finance and mortgage loans
The difference between long-term and short-term finance is that former are secured on completed buildings whereas the latter are issued before construction. Hence capital is much safer, although not liquid. Profit to occupant is contained by the difference in interest payable and the rental income.
The difference between long-term and mortgage hold is that former are repaid in installments consisting of interest payments plus capital repayments on a regular basis. In mortgage hold, borrower is required to pay only the interest until the end of loan period and pay back the capital at the end. Other modes of repayment also exist for long term loans.
Types of long term finance are based on the kind of development that is involved. Accordingly, long term finance takes form of housing loans, industrial loans and commercial loans.

Long term finance includes:

1. Finance to purchase undeveloped land and construct property. Both land and proposed property is security in mortgage. Loan is issued in stages of construction and repayment starts after the construction period, agreed upon between the lender and borrower.


2. Finance to purchase a finished property. Depreciation at the time of purchase may be an important factor in the quantum of loan. Repayment starts immediately after occupation.


3. Finance to renovate a property. Usually existing construction is security in this case. Loan is issued in stages of renovation work and repayment starts after the development period,that is agreed upon by the lender and borrower.

Housing Finance
Housing finance is a long term loan where land use is residential. Being a long term loan, housing loans are issued by banks or private lenders who support long term lending or more predominantly by financial institutions. The general term housing finance includes and encompasses following types of loans.

1. Purchase of land


2. Construction of house


3. Expansion or renovation of house


4. Purchase of house or apartment


5. Refinance of completed loans by mortgage

Features of Housing Loans
Housing finance industry predominantly consists of two types of service providers.
First and more common, the financial institutions such as HDFC, LIC etc. They procure money from small investors by insurance schemes, provident funds, family welfare schemes, gratuity funds etc. These funds are not reimbursed to the small investors in principal or interest until a maturity period. Hence, institutions have the benefit of long term holding of funds. So they are capable of investing on long term assets such as real property and securities, whence they are called Institutional Investors (FII).
Second types of players in the housing finance industry are banks, mutual/benefit funds and private lenders. In most cases, these lenders are unable to hold loans for long periods. However, some companies supported by long standing fixed deposit and savings schemes from small investors do provide long term loan facilities.

Common features of housing loans are enumerated as follows.

1. All housing loans are mortgage loans i.e. the banks remain in possession of the title deeds of the property and execute a first mortgage agreement with the owner entitling the banks to sell the property to recover the loan in case of default.


2. Housing loans are repaid by the borrower from his personal income such as salary or profit of business. Hence, lenders of housing loans require evidences of income of the borrower in addition to security. In most cases, it is possible to include the collective income of spouse or other joint applicants of loan.


3. Occasionally, banks may also require additional security such as guarantor and/or life insurance policies. Sometimes additional or collateral security may also be asked for. Government promissory notes, securities and fixed deposits are also accepted by few banks


4. Usually most lenders issue housing loans up to 85% of cost of the house. The other 15% (called seed money) needs to be provided by the borrower himself. The loans are disbursed in stages: upon identification of property, execution of legal documents and/or various stages of construction.


5. Normal rates of interest on housing loans vary from 5-15%. Interest rates may vary according to rules and sops introduced by the government and special offers given by companies towards marketing finance. Many banks offer fixed rate of interest that do not change with fluctuations in the market, whereas others offer floating rates of interest that changes with market conditions.


6. The repayment period may be varied at convenience between 5-20 years. The term usually does not extend beyond retirement age or 65 years age of the borrower whichever is earlier.


7. Housing loans are repaid by the borrower in monthly installments along with principal and interest. There are different types of installment schemes. Most banks offer Equal Monthly Installment (EMI) mode of repayment. Housing finance companies are entitled to collect post dated cheques towards EMIs over the repayment period.


8. The EMI comprises of both principal and interest and its value for a particular amount of loan over particular repayment period at a given interest rate depends on the period of interest calculation. Interests may be calculated on annually, monthly or daily basis. When there is a delay between commencement of EMI and disbursement of loans, the borrower may be required to pay the interest alone on the outstanding balance as pre-EMI interest.


9. Both principal as well as interest paid on housing loans involve tax benefits to the borrower. Tax deduction amounts to 15-20% of principal and interest payments can accommodated as outgoings before tax.


10. Most institutions charge a processing and/or documentation fees while processing and sanctioning the application apart from the interest. Processing fees are usually a fixed sum or sometimes a percentage of the loan amount.


11. Most institutions charge a penalty of 1-2% of outstanding due for closing a loan by paying back the principal before completion of the repayment period. This is called pre-payment penalty. Some institutions also charge a commitment fees for non-utilization of a sanctioned loan within a specified period.


12. For legal requirements, issue of housing loans require in addition to documents pertaining to the property, documents concerning identity, age and address of the borrower, credentials with bank accounts and documents relating to income and tax standing of borrower.

Selection of Housing Finance Parameters
Following observations are useful in determination of housing loan parameters on EMI basis.

1. For given loan amount, repayment period and rate of interest, EMI is lower for monthly balance schemes than annual balance schemes and is even lower for daily balance schemes. This is unless the savings in interest is offset by increased processing fees or other service charges.


2. For a given loan amount at a given rate of interest and calculation period, EMI reduces with increase in repayment period. The reduction is drastic from 5 to 15 years of repayment. Beyond this period, the reduction is slow.


3. For a given loan amount at a given rate of interest and calculation period, total amount repaid increases with increase in repayment period. The increase is gradual from 5 to 15 years, thereafter there may be drastic increase.


4. It is advantageous for the borrower to avail floating rate of interests when there is possibility of reduction of retail prime lending rates (PLR) in future. But when interest rates are likely to go up, fixed rate of interests are more beneficial to the borrower.


5. When a fixed rate of interest has been availed by a borrower in uncertainty of future market lending rates, it is advisable to avail a balance transfer facility with another bank offering an interest lower than the current rate, prepayment penalty and new processing charges put together.

Selection of Bank
Housing finance is an active sector in the finance industry even in the worst of times. With the entry of (subsidiaries of) multinational financial institutions and the growth of Indian institutions to international standards have contributed in various ways to the housing finance segment.
In general, while choosing financial institutions for procuring housing loans, borrowers look for following aspects.

1. Criterion of eligibility: Enhanced value of housing loans can be claimed from lending institutions by considering age, qualifications, spouses income, number of dependants, assets and liabilities, savings history and credit repayment as eligibility criterion in addition to income.


2. Processing time: Formalities of processing, paperwork involved etc. have come down considerably with improved systems of automation. In ideal cases, processing time should be less than 15 days. Most banks can sanction loan in matter of hours with proper documents. Many banks may also offer sanction the loan even before identification of the property.


3. Rates of interest: The lending rate war among companies are constantly bringing down the rates until, they may reach the minimum stipulations specified by the central bank of the country. It is advantageous to avail floating rate of interests in which interest rate responds dynamically to the sops introduced by government and market competition. But when retail prime lending rates (PLR) are likely to go up, fixed rate of interests are more beneficial to the borrower. When bank interest rates do not change while market rates changes, it is possible to arrange balance transfer facility with another bank. By balance transfer, the outstanding dues to bank charging higher interest are transferred to another bank that charges lower interest.


4. Reducing Principal: Almost all banks offer equal monthly installment based repayment, where the equated installment pays back both principal and interest steadily. While calculating reducing balance it is advantageous for the borrower to keep the calculating period to be lesser. Daily reducing schemes are more preferable than monthly reducing schemes, which are in turn better than annual reducing schemes.


5. Accessibility features: Availability of ATM, phone and net banking facilities make services of lenders more attractive


6. Benefits and incentives: Additional benefits such as free accident and property insurance to the extent of loan outstanding, discounts of interest and waiver of processing fees, prepayment penalty, commitment fees etc. are decisive factors in selection of institution.


7. Flexibility of schemes: Finance schemes should offer flexibility of schemes in terms of interest rates and repayment period. Many banks allow payment of outstanding dues ahead of repayment period with an intention to save interest. The facility to close account before repayment period and amount of prepayment penalty are decisive factors in selection of banks. Daily balance schemes make repayment more flexible, as an occasionally large deposit can be adjusted against outstanding balance to reduce interest costs.

Eligibility Criterion
Housing loans are repaid by the borrower from his personal income such as salary or profit of business. Hence, lenders of housing loans calculate eligible loans based on the income certificates. However, banks can be negotiated for higher values based on following considerations.

1. Age and qualification of the borrower: Younger the age and higher the qualifications, future earning prospects are brighter. As a result, higher estimates of eligible loans can be permissible.


2. Income of spouse or other family members: Income of spouse or other family members may be cited to enhance loan amounts, provided the joint applicants permit such arrangement.


3. No. of dependants: Lesser number of dependants may be used to advantage in calculating possible repayment of EMI.


4. Assets and Liabilities: Existing assets such as cars, stocks, shares and consumer durables increase confidence of lender on the applicant


5. Savings history: If applicant has remarkable savings history, this can be reliable evidence for credit worthiness. Many banks have innovative schemes where savings deposited in bank is considered against principal outstanding, so that interest may reduce. These savings deposits can also be withdrawn on requirement, so that interest is recalculated again on outstanding principal.


6. Credit repayment history: Banks where borrowers have a previous history of successful credit repayment, such as by credit cards, vehicle loans or personal loans support initiatives of the borrowers better.

Installment Schemes
Usually, during initial stages after development, projects fetch lesser revenue and revenue increases later either through increased demand or through inflation. Hence, the occupant pays installments more than incoming cash flow during the initial stages, whereas returns become more than outgoing installments at a later stage.
The arrangement of installments vary from institution to institution. Two extremes can be identified.

In Diminishing Monthly Installments, borrower pays constant installments of capital repayment every month, so that the interest on outstanding capital diminishes continuously. According to this scheme, borrower has to pay larger amounts during initial stages when the revenue from development is not fully matured.

In Equal Monthly Installments, borrower pays constant installments every month so that interest payments are larger initially and capital payments are larger towards the end. The EMI scheme appears convenient because it delays large payments until returns from development can be fully realized.